Central Bank Papers on Monetary Policy Frameworks in the ... · in implementing the monetary policy objectives as it gives the CBUAE early warning signals of developments in the local

Central Bank Papers on Monetary Policy

Frameworks in the Arab Countries

AMF-BIS Second Working Party Meeting on

Monetary Policy in the Arab Region

Arab Monetary Fund (AMF) Abu Dhabi, United Arab Emirates

15–16th November 2017

Papers in this volume were prepared for the Second working party meeting of senior officials from Arab central banks organized by the Arab Monetary Fund (AMF) and Bank for International Settlements (BIS) in Abu Dhabi, the United Arab Emirates in November 2017. The views expressed are those of the authors and do not necessarily reflect the views of the AMF or BIS, or the central banks represented at the meeting. Individual papers (or excerpts thereof) may be reproduced or translated with the authorization of the authors concerned.

Papers in this volume were prepared for the Second working party meeting of senior officials from Arab central banks organized by the Arab Monetary Fund (AMF) and Bank for International Settlements (BIS) in Abu Dhabi, the United Arab Emirates in November 2017. The views expressed are those of the authors and do not necessarily reflect the views of the AMF or BIS, or the central banks represented at the meeting. Individual papers (or excerpts thereof) may be reproduced or translated with the authorization of the authors concerned.

Table of Contents

Foreword IV

Background Papers on Monetary Policy: Arab Countries

- The Central Bank of Jordan. 1

- The Central Bank of the United Arab Emirates. 11

- The Central Bank of Bahrain. 21

- The Central Bank of Tunisia. 37

- The Saudi Arabian Monetary Authority. 55

- The Central Bank of Sudan. 63

- The Central Bank of Iraq. 70

- The Central Bank of Oman. 75

- The Palestine Monetary Authority. 89

- The Central Bank of Kuwait. 107

- Banque Du Liban. 115

- The Central Bank of Morocco. 125

- The Central Bank of Mauritania. 147

Background Papers on Monetary Policy: International Central

Banks

- European Central Bank (ECB). 157

v

Foreword

Papers collected in this volume were written for the Second Working Party on Monetary

Policy in the Arab region organized jointly by the Arab Monetary Fund (AMF) and the

Bank for International Settlements (BIS) in Abu Dhabi, the United Arab Emirates on

November 15–16th, 2017. The purpose of this meeting was to review recent global and

regional economic developments and to exchange views on the implications for

monetary and financial policies in the Arab region. The meeting was attended by

participants from 25 central banks and monetary authority agencies. Nine central banks

from outside the Arab region took part.

The meeting provided an opportunity to review analysis about many important issues

related to monetary policies in the Arab countries. Topics included recent economic

and financial market developments and their implications for banks in the Arab Region;

bank funding and liquidity amidst lower oil prices and rising public debt; and the

Islamic banks in hybrid banking systems. The meeting also tackled other technical

issues related to the prospects for monetary policy in the Arab countries; monetary

policy operating frameworks; and exchange rate regimes and inflation.

Papers on the operational frameworks and the implementation of monetary policy in

thirteen Arab countries were presented and discussed during the meeting. The papers

were subsequently revised by the authors and are published to stimulate discussion.

They do not necessarily reflect the views of the AMF or the BIS.

On the experiences of Arab countries adopting fixed exchange rate regimes, the paper

of the Central Bank of Jordan (CBJ) focuses on the evolution of the monetary policy

framework during the last five decades. During its trajectory, the CBJ faced different

economic and political challenges and many critical points, either on the local, regional

or global level. In addressing these challenges, monetary policy played an essential role.

A well-designed and well-implemented monetary policy is a fundamental factor if the

kingdom is to achieve sustainable growth and high welfare levels. Given the

characteristics of the Jordanian economy as a small open economy with strong ties to

external economies, the scale of these challenges has confronted the CBJ with a difficult

situation to manage. The CBJ’s monetary policy shows a very high degree of flexibility

in dealing with these extraordinary events in an efficient and successful way. The

vi

several updates of the monetary policy instruments, objectives, and decisions to adapt

to economic challenges cover a wide spectrum that ranges from introducing open

market operations, switching to indirect monetary policy management, the adoption of

financial stability as an additional target for the CBJ and the introduction of the corridor

system.

The paper of the Central Bank of the UAE (CBUAE) reviews the current operational setup of the implementation of monetary policy in the UAE in line with the key policy objective, which is to maintain a stable and convertible domestic currency. Historically, the dirham’s (AED) peg to the US dollar has served the UAE well, with relatively stable growth and moderate inflation. The exchange rate regime benefits the UAE by reducing transaction costs and foreign exchange risks for UAE firms and minimizing volatility caused by capital flows. The long-term benefits of the current regime are self-evident in the ongoing diversification of the UAE economy, as the stability of the exchange rate peg has encouraged the investment necessary to achieve such ends.

Monitoring the liquidity stance within the banking sector is another important element

in implementing the monetary policy objectives as it gives the CBUAE early warning

signals of developments in the local dirham market. In this regard, the CBUAE’s role

is to provide banks operating in the UAE with many alternative monetary tools to assist

them in their daily liquidity management exercise. The CBUAE has introduced new

monetary tools, including new standing facilities, as part of its monetary management

framework in addition to its CDs. The paper confirms that the CBUAE will continue to

maintain a ‘comfort zone’ for interest rates through the usage of the various existing

instruments while introducing new facilities as necessary to manage liquidity in the

banking system in line with priorities for non-energy growth while safeguarding the

stability of the exchange rate system.

The paper of the Central Bank of Bahrain (CBB) focuses on liquidity management in

Islamic banks and the implications for monetary policy. It highlights the liquidity

instruments which are made available by the CBB for Islamic banks, under its monetary

policy operations, to enable the Islamic banks to manage liquidity positions. Bahrain,

as an Islamic financial center in the region, is geared to promoting the growth of Islamic

finance in numerous ways to cater for the increasing investor demand for Sharia-

compliant financial products and services. The CBB has pioneered in addressing

vi

several updates of the monetary policy instruments, objectives, and decisions to adapt

to economic challenges cover a wide spectrum that ranges from introducing open

market operations, switching to indirect monetary policy management, the adoption of

financial stability as an additional target for the CBJ and the introduction of the corridor

system.

The paper of the Central Bank of the UAE (CBUAE) reviews the current operational setup of the implementation of monetary policy in the UAE in line with the key policy objective, which is to maintain a stable and convertible domestic currency. Historically, the dirham’s (AED) peg to the US dollar has served the UAE well, with relatively stable growth and moderate inflation. The exchange rate regime benefits the UAE by reducing transaction costs and foreign exchange risks for UAE firms and minimizing volatility caused by capital flows. The long-term benefits of the current regime are self-evident in the ongoing diversification of the UAE economy, as the stability of the exchange rate peg has encouraged the investment necessary to achieve such ends.

Monitoring the liquidity stance within the banking sector is another important element

in implementing the monetary policy objectives as it gives the CBUAE early warning

signals of developments in the local dirham market. In this regard, the CBUAE’s role

is to provide banks operating in the UAE with many alternative monetary tools to assist

them in their daily liquidity management exercise. The CBUAE has introduced new

monetary tools, including new standing facilities, as part of its monetary management

framework in addition to its CDs. The paper confirms that the CBUAE will continue to

maintain a ‘comfort zone’ for interest rates through the usage of the various existing

instruments while introducing new facilities as necessary to manage liquidity in the

banking system in line with priorities for non-energy growth while safeguarding the

stability of the exchange rate system.

The paper of the Central Bank of Bahrain (CBB) focuses on liquidity management in

Islamic banks and the implications for monetary policy. It highlights the liquidity

instruments which are made available by the CBB for Islamic banks, under its monetary

policy operations, to enable the Islamic banks to manage liquidity positions. Bahrain,

as an Islamic financial center in the region, is geared to promoting the growth of Islamic

finance in numerous ways to cater for the increasing investor demand for Sharia-

compliant financial products and services. The CBB has pioneered in addressing

challenges faced by the Islamic banks and introduced Sharia-compliant Islamic

securities and paved the way for Islamic banks to introduce Sharia-compliant financial

instruments, banking products/services. The CBB has created a level playing field

between Islamic and conventional banking in its liquidity management tools available

to banks and in its payment infrastructure.

Having considered the prospective constraints of Islamic banks, the CBB puts special

emphasis on maintaining a level playing field between conventional and Islamic banks

as they operate in the interbank market and the payment systems (such as the RTGS-

SSS system and retail payment systems) and use tools available for liquidity

management.

The paper of the Saudi Arabian Monetary Authority (SAMA) shows how recent oil

price developments have impacted the liquidity of the Saudi financial system and sets

out the experience of the SAMA in managing and dealing with system-wide liquidity

tightening. It highlights the approach and tools used by SAMA in this regard, along

with their impact on the system. Given the nature of the Saudi economy and its financial

system, liquidity management is an important part of SAMA’s role in maintaining a

stable monetary and financial system. With the recent macroeconomic developments,

this role has become more vital than ever. Even though the Saudi banking system has

long been characterized as a system with ample liquidity, the recent liquidity tightness

shows how quickly liquidity conditions can weaken. In addition, it magnifies the need

for more coordination between fiscal policy, public debt strategy, and monetary policy.

Anchoring market expectations about economic and financial developments is a driving

factor in ensuring stable movements in system liquidity. Moreover, it highlights the role

that macroprudential policy can play in terms of offering complementary measures in

achieving adequate liquidity in the system. As a result, communication with the

financial sector as well as with government agencies was made clearer and more

transparent. Finally, government plans for future debt issuances were designed in

accordance with financial developments and in coordination with SAMA.

The paper of the Central Bank of Iraq (CBI) sheds light on the central bank’s efforts

to restore economic and financial stability. The year 2017 has witnessed the

implementation of many serious and ambitious reforms and measures. These efforts

viii

have resulted in a second upgrade for Iraq’s credit rating by the international rating

agencies S&P and Fitch, to B– with a stable outlook.

Within its priorities, the Central Bank of Iraq has accorded the utmost importance to

supporting private sector lending through credit facilities totalling 5 trillion Iraqi dinars

for agriculture, industrial, real estate banks and the housing fund in an attempt to

reconstruct infrastructure and reduce unemployment, in addition to supporting small

and medium-sized enterprises.

The paper of the Central Bank of Oman (CBO) highlights the latest macroeconomic,

monetary and banking sector developments. Like the other GCC countries, Oman has

witnessed an economic slowdown, due to falling oil prices. The steep drop in oil prices

also resulted in twin deficits in the fiscal and current accounts. The government has,

however, undertaken several reform measures to reinstate the macroeconomic balance

and promote diversification to reduce excessive dependence on the hydrocarbon sector.

The recovery in oil prices from the low of early 2016, coupled with positive results

produced by reform measures, has led to an upturn in the economy, and nominal GDP

grew by 12.3 percent during 1H 2017 as against a negative 11.1 percent in 1H 2016.

Although monetary conditions have tightened somewhat mainly reflecting the

conditions in the US, credit has continued to grow in line with domestic economic

activities, especially to non-oil activities. The banks have also displayed resilience,

despite the economic slowdown and deceleration in business activities, and they have

maintained a good capital base while containing their delinquency rate. At the same

time, banks were able to post reasonable profits in 2016, although lower than in the

previous year.

Going forward, the economic recovery is expected to strengthen in light of the

anticipated further increase in oil prices (as a result of continuous supply management

efforts by OPEC and non-OPEC countries and robust global demand) and various

policy initiatives, such as diversification under the “Tanfeedh” program, which is

expected to have accelerated results. Implementation of VAT and approval for labour

and FDI legislation would help greatly to improve Oman’s robust macroeconomic

outlook over the medium term.

viii

have resulted in a second upgrade for Iraq’s credit rating by the international rating

agencies S&P and Fitch, to B– with a stable outlook.

Within its priorities, the Central Bank of Iraq has accorded the utmost importance to

supporting private sector lending through credit facilities totalling 5 trillion Iraqi dinars

for agriculture, industrial, real estate banks and the housing fund in an attempt to

reconstruct infrastructure and reduce unemployment, in addition to supporting small

and medium-sized enterprises.

The paper of the Central Bank of Oman (CBO) highlights the latest macroeconomic,

monetary and banking sector developments. Like the other GCC countries, Oman has

witnessed an economic slowdown, due to falling oil prices. The steep drop in oil prices

also resulted in twin deficits in the fiscal and current accounts. The government has,

however, undertaken several reform measures to reinstate the macroeconomic balance

and promote diversification to reduce excessive dependence on the hydrocarbon sector.

The recovery in oil prices from the low of early 2016, coupled with positive results

produced by reform measures, has led to an upturn in the economy, and nominal GDP

grew by 12.3 percent during 1H 2017 as against a negative 11.1 percent in 1H 2016.

Although monetary conditions have tightened somewhat mainly reflecting the

conditions in the US, credit has continued to grow in line with domestic economic

activities, especially to non-oil activities. The banks have also displayed resilience,

despite the economic slowdown and deceleration in business activities, and they have

maintained a good capital base while containing their delinquency rate. At the same

time, banks were able to post reasonable profits in 2016, although lower than in the

previous year.

Going forward, the economic recovery is expected to strengthen in light of the

anticipated further increase in oil prices (as a result of continuous supply management

efforts by OPEC and non-OPEC countries and robust global demand) and various

policy initiatives, such as diversification under the “Tanfeedh” program, which is

expected to have accelerated results. Implementation of VAT and approval for labour

and FDI legislation would help greatly to improve Oman’s robust macroeconomic

outlook over the medium term.

ix

The paper of the Central Bank of Kuwait (CBK) refers to the recent increase in the

level of government public debt financed partly by the issuances of government

treasury bills and bond. The paper confirmed that the increase in government securities

investment has helped the banking sector to diversify its investment portfolio by

investing more in domestic public debt, contributing thereby to the development of a

liquid local currency debt market. However, the capacity of the banking sector to absorb

government debt without crowding out private credit has been a concern. To counter

any risk of private sector crowding-out, the CBK has closely worked with the Ministry

of Finance to keep government borrowing from domestic banks within an acceptable

range.

The paper highlights the importance of fiscal and structural reforms to address future

challenges. On the other hand, the status quo of Kuwait monetary policy may be

disrupted by external events. To consider one scenario, if the target federal funds rate

is raised further, there may be a need to revise the CBK’s discount rate. On the exchange

rate level, the paper confirms that the present policy of pegging the Kuwaiti dinar

exchange rate to a basket of currencies has served the country well, delivering monetary

policy credibility and low inflation. Given the structure of the Kuwaiti economy which

is characterized by heavy reliance on a single commodity, there is no need to change

the current exchange rate regime, nor is there any benefit to gain from doing so.

Banque Du Liban (BDL) highlights in its paper the role of the central bank in

safeguarding the national currency and maintaining financial and economic stability

and to ensure that the Lebanese economy in general, and the financial sector, are strong,

sound and resilient. The policies undertaken by the BDL have proven their success and

have been recognized as major drivers of the Lebanese economy. The paper stressed

that the BDL will remain vigilant as to the financial and economic needs of Lebanon

and will continue to be proactive in the face of persisting challenges.

To ensure sustainable development and to pave the way for real inclusive growth, the

government needs to undertake many structural reforms: revamping infrastructure,

enhancing the quality and quantity of public services, simplifying administrative

procedures, enforcing fiscal discipline, reforming the energy sector, and passing the

budget law, among other measures. The BDL has striven to create an environment that

promotes the banking and financial sectors on the one hand, and the knowledge

x

ecosystem on the other, with the expectation that the government would, in turn,

support the creation of the necessary environment for cross-sectoral economic growth.

On the experiences of monetary policy management in Arab countries with more

flexible exchange rate regimes, the paper of Bank Al-Maghrib (BAM) indicated that

the framework for the conduct of monetary policy in Morocco has been substantially

overhauled in the recent years to better adapt it to changes in the Moroccan economy

in general and the financial system in particular.

In 2006, monetary policy saw a turning point with the adoption of the new statute of

Bank Al-Maghrib, by which the maintenance of price stability has become one of the

core missions of the central bank. The new statute has also given it more autonomy in

the conduct of monetary policy. Since then, BAM has worked to strengthen monetary

policy implementation framework to align it with best practices.

In 2013, under its three-year strategic plan 2013–2016, BAM set the strategic goal of

adapting the framework for the conduct of monetary policy in preparation for the

expected transition to a more flexible exchange rate regime and inflation targeting.

Consequently, it started the development of a new forecasting and policy analysis

system (FPAS) capable of supporting the planned transition. The latter consists of a

central monetary policy model (MQPM) that helps to produce medium-term forecasts

and integrates a structural model (MOPAM) for the simulation of medium and long-

term impacts of public policies and structural reforms.

In 2016, this framework was rolled out, and a new forecasting process was put in place.

The latter has helped to strengthen interaction within the forecasting team on the one

hand and between the forecasting team and monetary policy governance bodies on the

other hand. In particular, a new committee was set up to examine macroeconomic

projections prior to submission to the Monetary and Financial Committee (MFC) and

then to the Bank Board. At the same time, communication on monetary policy has been

adjusted as well, by reinforcing policy guidance and improving the transparency of the

decision-making process.

On the other hand, the paper of the Central Bank of Tunisia (CBT) sheds light on the

impact of some internal and external challenges that have greatly affected the country’s

macroeconomic performance and business climate over the last six years.

x

ecosystem on the other, with the expectation that the government would, in turn,

support the creation of the necessary environment for cross-sectoral economic growth.

On the experiences of monetary policy management in Arab countries with more

flexible exchange rate regimes, the paper of Bank Al-Maghrib (BAM) indicated that

the framework for the conduct of monetary policy in Morocco has been substantially

overhauled in the recent years to better adapt it to changes in the Moroccan economy

in general and the financial system in particular.

In 2006, monetary policy saw a turning point with the adoption of the new statute of

Bank Al-Maghrib, by which the maintenance of price stability has become one of the

core missions of the central bank. The new statute has also given it more autonomy in

the conduct of monetary policy. Since then, BAM has worked to strengthen monetary

policy implementation framework to align it with best practices.

In 2013, under its three-year strategic plan 2013–2016, BAM set the strategic goal of

adapting the framework for the conduct of monetary policy in preparation for the

expected transition to a more flexible exchange rate regime and inflation targeting.

Consequently, it started the development of a new forecasting and policy analysis

system (FPAS) capable of supporting the planned transition. The latter consists of a

central monetary policy model (MQPM) that helps to produce medium-term forecasts

and integrates a structural model (MOPAM) for the simulation of medium and long-

term impacts of public policies and structural reforms.

In 2016, this framework was rolled out, and a new forecasting process was put in place.

The latter has helped to strengthen interaction within the forecasting team on the one

hand and between the forecasting team and monetary policy governance bodies on the

other hand. In particular, a new committee was set up to examine macroeconomic

projections prior to submission to the Monetary and Financial Committee (MFC) and

then to the Bank Board. At the same time, communication on monetary policy has been

adjusted as well, by reinforcing policy guidance and improving the transparency of the

decision-making process.

On the other hand, the paper of the Central Bank of Tunisia (CBT) sheds light on the

impact of some internal and external challenges that have greatly affected the country’s

macroeconomic performance and business climate over the last six years.

xi

Aware of these difficulties, the government is engaged in a five-year economic program

(2016–2020) to build a strategy conducive to macroeconomic and financial stability.

Six years after the 2011 revolution, the Tunisian economy is still evolving in a

challenging environment that has resulted in deepening twin deficits due to low

economic growth.

The twin deficits make the conduct of monetary policy a difficult task. Fiscal policy is

conducted in a countercyclical manner mainly to stabilize social conditions, through

wage increases and higher subsidies, despite weak growth rates. At the same time, this

narrows the space for fiscal manoeuvre, increasing the vulnerabilities of the country as

shown through the soaring debt-to-GDP ratio.

The Central Bank of Tunisia is mandated by law to preserve price stability through its

proactive monetary policy. It has the responsibility to face the adverse effects of the

former expansionary fiscal policy on the one hand, and the new set of measures to be

taken in the framework of Budget Law to increase taxes, on the other hand, by a further

tightening of its monetary policy at the time when the economic recovery is still fragile.

These challenges will take time to overcome.

The paper of Central Bank of Sudan (CBOS) sheds light on the experience of Sudan

as a fully-fledged Islamic banking system since 1983. Sudan’s economy offers an

experience that enriches the monetary policy literature in the Arab region, adds unique

perspectives, and provides valuable lessons. It demonstrates that Islamic monetary and

financial systems can exhibit significant resilience to the global financial crisis by

avoiding the effects of direct spillovers. However, they may be less effective in

shielding against second-round crisis effects. The paper revisits the experience of the

CBOS in managing the monetary policy considering the limited policy instruments

within the context of fully fledged Islamic system. Various central banks find the

required reserve ratio (RRR) to be handy as a macro liquidity management tool.

Nonetheless, it may not be equally convenient for day-to-day adjustment of liquidity

levels. Thus, readily available supplemental liquidity mop-up instruments may be

advisable for countercyclical purposes. Furthermore, where the RRR is numerated, it

costs the central bank, and, where it is not, it resembles a tax on the commercial banks.

It is worth noting that the RRR works better where the interbank market exists and is

developed. As such, it is advisable for Islamic central banks to pay special attention to

xii

developing and deepening interbank markets and familiarize themselves with

Mudaraba contracts. The challenge of ensuring an adequate supply of Islamic monetary

policy tools at the disposal of the central bank calls for a proactive approach towards

developing an arsenal of Sharia-compliant instruments for countercyclical use.

The paper of Central Bank of Mauritania (CBM) highlights the evolution of

monetary policy in Mauritania, where monetary policy is a component of overall

economic policy and its main objective is price stability. The task of conducting

monetary policy is assigned to the central bank, which has exercised it effectively since

its creation. However, monetary policy has recently faced some challenges that affect

its effectiveness as the key interest rate has lost its influence and the monetary policy

main objective has shifted in favor of exchange rate stability.

Right now, and in order to increase the efficiency of monetary policy, more efficient

and dynamic, structural, and organizational changes are taking place, namely the new

draft operational framework currently being validated by the Monetary Policy Council,

which proposes, on the one hand, a set of instruments enabling the central bank to

manage the country’s money market, and, on the other hand, the establishment of

monetary policy decision-making bodies to facilitate exchange rate and monetary

policy actions.

On the experience of Palestine Monetary Authority (PMA) where there is no

domestic currency, the paper sheds light on the implications of some key aspects on

monetary and financial policy and stability referring to four main sources of potential

challenges on the banking sector including credits granted to non-residents, changes in

interest rates, exchange rates of the main partners and placements abroad.

The PMA serves a broad range of central banking functions as envisaged in the Paris

Protocol. However, the PMA monetary policy framework is still limited since the PMA

does not issue its own currency. In line with its main objective to secure the stability of

the banking and monetary system, the PMA does not refinance banks or act as lender

of last resort but provides liquidity support to banks in certain cases.

Without a domestic currency, the available policy tools are limited and mainly used for

prudential purposes; the PMA has no control over the domestic money supply and little

xii

developing and deepening interbank markets and familiarize themselves with

Mudaraba contracts. The challenge of ensuring an adequate supply of Islamic monetary

policy tools at the disposal of the central bank calls for a proactive approach towards

developing an arsenal of Sharia-compliant instruments for countercyclical use.

The paper of Central Bank of Mauritania (CBM) highlights the evolution of

monetary policy in Mauritania, where monetary policy is a component of overall

economic policy and its main objective is price stability. The task of conducting

monetary policy is assigned to the central bank, which has exercised it effectively since

its creation. However, monetary policy has recently faced some challenges that affect

its effectiveness as the key interest rate has lost its influence and the monetary policy

main objective has shifted in favor of exchange rate stability.

Right now, and in order to increase the efficiency of monetary policy, more efficient

and dynamic, structural, and organizational changes are taking place, namely the new

draft operational framework currently being validated by the Monetary Policy Council,

which proposes, on the one hand, a set of instruments enabling the central bank to

manage the country’s money market, and, on the other hand, the establishment of

monetary policy decision-making bodies to facilitate exchange rate and monetary

policy actions.

On the experience of Palestine Monetary Authority (PMA) where there is no

domestic currency, the paper sheds light on the implications of some key aspects on

monetary and financial policy and stability referring to four main sources of potential

challenges on the banking sector including credits granted to non-residents, changes in

interest rates, exchange rates of the main partners and placements abroad.

The PMA serves a broad range of central banking functions as envisaged in the Paris

Protocol. However, the PMA monetary policy framework is still limited since the PMA

does not issue its own currency. In line with its main objective to secure the stability of

the banking and monetary system, the PMA does not refinance banks or act as lender

of last resort but provides liquidity support to banks in certain cases.

Without a domestic currency, the available policy tools are limited and mainly used for

prudential purposes; the PMA has no control over the domestic money supply and little

xiii

influence on domestic interest rates, and inflation. Because of the lack of a domestic

money market, domestic government securities, and a yield curve, it does not conduct

open market operations. However, the PMA can influence the economy through its

prudential regulations and related policy tools such as (i) reserve requirements, and (ii)

placement of reserves at commercial banks to support liquidity.

Therefore, the credit channel is the main transmission channel of monetary policy. Due

to the limited set of policy instruments, monetary policy has virtually no influence on

exchange rates, interest rates, and asset prices. However, it can influence the credit

supply to the private sector by altering the incentives for bank lending and, for the

composition of banks’ loan portfolios.

In conclusion, the meeting served to give policy-makers much food for further

reflection. Although specific national circumstances differ, there are many common

elements in the formulation of monetary and financial policies. Central banks can learn

much from each other.

Central Bank Papers on Monetary Policy Frameworks in the Arab Countries

AMF-BIS Second Working Party Meeting on Monetary Policy in the Arab Region

The Hashemite Kingdom of Jordan

H.E. Dr. Adel Alsharkas

Deputy Governor Central Bank of Jordan

Abu Dhabi, United Arab Emirates 2017November th61–15

Central Bank Papers on Monetary Policy Framework in the Arab Countries

Monetary Policy Developments in The Hashemite Kingdom of Jordan

1. Introduction Jordan is a country with a small open economy, limited natural resources and low incomes. In addition to the almost complete reliance on imported energy sources, Jordan is considered one of the most water-stressed countries in the world in 2040. As a result, the Jordanian relations with neighboring countries play a significant role in its economic growth and social welfare level.

The limited resources accompanied by low incomes of a developing country like Jordan have two important effects (among other effects) on its economy. The first effect is the low saving ratios and hence investment levels. Second, the taxable capacity will be limited, and government earnings will be low. These two effects, which lead to a twin saving-investment and budget deficits, forced the high reliability of the Jordanian economy on foreign capital inflow.

The Jordanian strong economic relationships with neighboring countries are clearly manifested in many ways. The flow of migrants due to political conflicts in the area, which enforced and directed tremendous waves of immigrants to Jordan and called for appropriate international community assistants inflows, to accommodate these waves effects. The continuous inflow of unskilled workers, the outflow of skilled workers and the relative big size of trade with the neighboring countries, exacerbate the instability effects in the area on the Jordanian economy. The capital flow to Jordan took different shapes (financial aid, grants, loans, foreign direct investments, technical assistance, and workers remittances).

Within this context, the surrounding instability, the atmosphere of uncertainty, and political shocks in the area created a huge external debt burden and hence, high-pressures on the Jordanian economy, mainly the balance of payments, foreign reserves, and as a result, the GDP growth rate retracted and the economy inflation rates witnessed increase.

Apparently, these situations created important challenges to be considered by the policy-maker when seeking the optimality of the monetary policy, acknowledging that fiscal policy and monetary policy mainly have different objectives, and each in turn may mitigate the results of the other.

While monetary policy usually aims for stability in different macroeconomic variables, most importantly inflation, the actions of fiscal policy may lead, from


Monetary Policy Developments in The Hashemite Kingdom of Jordan

1. Introduction Jordan is a country with a small open economy, limited natural resources and low incomes. In addition to the almost complete reliance on imported energy sources, Jordan is considered one of the most water-stressed countries in the world in 2040. As a result, the Jordanian relations with neighboring countries play a significant role in its economic growth and social welfare level.

The limited resources accompanied by low incomes of a developing country like Jordan have two important effects (among other effects) on its economy. The first effect is the low saving ratios and hence investment levels. Second, the taxable capacity will be limited, and government earnings will be low. These two effects, which lead to a twin saving-investment and budget deficits, forced the high reliability of the Jordanian economy on foreign capital inflow.

The Jordanian strong economic relationships with neighboring countries are clearly manifested in many ways. The flow of migrants due to political conflicts in the area, which enforced and directed tremendous waves of immigrants to Jordan and called for appropriate international community assistants inflows, to accommodate these waves effects. The continuous inflow of unskilled workers, the outflow of skilled workers and the relative big size of trade with the neighboring countries, exacerbate the instability effects in the area on the Jordanian economy. The capital flow to Jordan took different shapes (financial aid, grants, loans, foreign direct investments, technical assistance, and workers remittances).

Within this context, the surrounding instability, the atmosphere of uncertainty, and political shocks in the area created a huge external debt burden and hence, high-pressures on the Jordanian economy, mainly the balance of payments, foreign reserves, and as a result, the GDP growth rate retracted and the economy inflation rates witnessed increase.

Apparently, these situations created important challenges to be considered by the policy-maker when seeking the optimality of the monetary policy, acknowledging that fiscal policy and monetary policy mainly have different objectives, and each in turn may mitigate the results of the other.

While monetary policy usually aims for stability in different macroeconomic variables, most importantly inflation, the actions of fiscal policy may lead, from


the point of view of monetary policy-makers, to instability in some macro-economic variables. In this regard, we can see the importance of one of the essential features of a well-established economic system that fosters the cooperation among various authorities, and the independence of the monetary authority.

In actual practices, specifically in the aftermath of the world financial crises, the optimality of monetary policy, while responding to fiscal policy shocks, involves the interaction between the stability in the financial sector (as a macro-prudential regulation) and the stability in price level (as a monetary policy objective). The tradeoff between the stability of the banking sector and the standard objectives of the monetary policy exemplified by the introduction of the macro-prudential regulations represented a major challenge to the monetary policy-maker worldwide. Jordan was not an exception, especially in the circumstances similar to those faced by the Central Bank of Jordan (CBJ) after 2012.

2. The Jordanian monetary policy objectives As the outbreak of the global financial crisis affected the economies of the whole world, and despite the fact that its impact on advanced economies was much deeper, it provoked significant challenges on the economic growth rates and enforced new challenges for Central Banks to manage their monetary policy. Hence, many countries witnessed a wide use of non-conventional instruments such as quantitative easing and macro-prudential regulations, accompanied with reducing interest rates to reach zero or even negative levels to stimulate economic growth.

Not far from these challenges, the CBJ updated its main objectives to be maintaining monetary and financial stability, and to keep a sustained and inclusive economic growth in the kingdom.

To achieve these objectives, the CBJ seeks to maintain the stability of the general price level, provide an interest rate structure in line with local and global economic developments, and to ensure the convertibility of the Jordanian dinar in light of the constraint of the exchange rate peg to the US dollar. Meanwhile, the CBJ is keen to maintain financial stability by enhancing the ability of other banking and financial institutions to face risks, as well as to enhance banking system in mobilizing savings and investments.


To have a better understanding of the monetary policy instruments used by the CBJ it worth to review the evolution of the monetary policy development in Jordan.

3. Monetary policy development in Jordan

The CBJ started exerting its activities in 1964, and up until the local economic and financial crisis in 1989, the Central Bank used direct monetary policy instruments by setting interest rates administratively, which caused price distortions in the banking market. In addition, the Central Bank directed credit towards certain sectors at preferential interest rates, which provoked inefficiency in employing loanable funds. During that period, the CBJ used direct monetary policy instruments, represented by the discount rate and the required reserve ratio to control domestic liquidity. In addition, the CBJ introduced Open Market Operations (OMOs) in 1988 to affect the liquidity level, through selling and buying public debt instruments over a narrow scope, due to the small size of these securities and their limited trading in the secondary market.

By the end of the year 1988, Jordan faced severe economic pressures led to a decrease in the Jordanian dinar exchange rate by almost the half and a decline in its purchasing power accompanied with high inflation rate that hit a record level exceeding 25%. The Jordanian economy entered in a shrinking stage, where the economic growth registered negative rates. The aforementioned developments pushed Jordan to adopt an economic consolidation program supported by the International Monetary Fund (IMF), to achieve macroeconomic stability, and control the imbalances in the general budget and the balance of payment.

Beginning of the year 1990, the CBJ started to switch toward indirect monetary policy management through introducing new monetary instruments consistent with economic developments and ensuring the achievement of monetary policy targets and liberalizing interest rates in the banking market.

Within this framework, the CBJ started influencing interest rates in the banking market through monetary policies that aim at containing the undesirable increase in the general price level, through using open market operations. The CBJ issued a special instrument, specifically, certificates of deposit of three/six months’ maturity, to absorb excess liquidity in banks and to control the liquidity growth in domestic economy.


To have a better understanding of the monetary policy instruments used by the CBJ it worth to review the evolution of the monetary policy development in Jordan.

3. Monetary policy development in Jordan

The CBJ started exerting its activities in 1964, and up until the local economic and financial crisis in 1989, the Central Bank used direct monetary policy instruments by setting interest rates administratively, which caused price distortions in the banking market. In addition, the Central Bank directed credit towards certain sectors at preferential interest rates, which provoked inefficiency in employing loanable funds. During that period, the CBJ used direct monetary policy instruments, represented by the discount rate and the required reserve ratio to control domestic liquidity. In addition, the CBJ introduced Open Market Operations (OMOs) in 1988 to affect the liquidity level, through selling and buying public debt instruments over a narrow scope, due to the small size of these securities and their limited trading in the secondary market.

By the end of the year 1988, Jordan faced severe economic pressures led to a decrease in the Jordanian dinar exchange rate by almost the half and a decline in its purchasing power accompanied with high inflation rate that hit a record level exceeding 25%. The Jordanian economy entered in a shrinking stage, where the economic growth registered negative rates. The aforementioned developments pushed Jordan to adopt an economic consolidation program supported by the International Monetary Fund (IMF), to achieve macroeconomic stability, and control the imbalances in the general budget and the balance of payment.

Beginning of the year 1990, the CBJ started to switch toward indirect monetary policy management through introducing new monetary instruments consistent with economic developments and ensuring the achievement of monetary policy targets and liberalizing interest rates in the banking market.

Within this framework, the CBJ started influencing interest rates in the banking market through monetary policies that aim at containing the undesirable increase in the general price level, through using open market operations. The CBJ issued a special instrument, specifically, certificates of deposit of three/six months’ maturity, to absorb excess liquidity in banks and to control the liquidity growth in domestic economy.


On October 1995, the CBJ has pegged the exchange rate of the Jordanian dinar to the US dollar, this regime has served our economy well over the past period, and it continues to underpin stability in Jordan’s open economy. In addition, it contributes to strengthening the confidence in the Jordanian dinar as an attractive savings instruments. Since then, the exchange rate peg regime inscribed the CBJ monetary policy, in the sense of maintaining the Jordanian dinar competitiveness by keeping a suitable margin between the interest rate on the Jordanian dinar and that on US dollar, monitoring dollarization, foreign reserves, and inflation in setting its monetary policy.

As an incentive for banks to use open market instruments to manage their liquidity, the CBJ introduced in 1998, the overnight deposit window. The interest rate on this window is considered as an indicator of the interest rate in the interbank market.

In 2007, the monetary policy witnessed a major shift in management methods by introducing the interest rates corridor system, which allows the Central Bank to intervene in the interbank market to affect the short-term interbank lending rate more efficiently and effectively. This system consists of two rates on overnight interbank transactions; one of which is the Overnight Deposit Rate, while the second is the Overnight Repo Rate. Banks deposit their excess liquidity at the CBJ at deposit rate, on the other side; banks borrow from the CBJ to cover their financial needs at the repurchase interest rate. According to these settings, the deposit window rate that represents the floor of the system, considered the reference for interest rates on deposit, while repurchase interest rate that represents the ceiling of the system, considered the reference for interest rates on loans and credit facilities. These rates used for the purpose of monetary policy management.

In the repercussions of the global financial and economic crisis in 2008, the CBJ adopted a flexible monetary and banking policy represented by gradual several expansionary monetary measures, taking into consideration the domestic and external developments. The most prominent was the reduction of the various monetary policy instruments interest rates between 2008 and 2010 by 2.75 percentage points, besides reducing the required reserve ratio on bank deposits three times to reach 7.0 percent in 2009. In addition, the CBJ stopped the issuance of Certificates of Deposit since October 2008, leaving more space for banks to provide credit for different sectors to support economic growth.


In the midst of high influx of Syrian refugees that started in 2011, the acceleration of the imports bill, especially energy, the high deficit in the government budget and current account, in addition to the lack of liquidity available for lending to all economic sectors, the kingdom faced huge economic pressures in 2012. As a result, the CBJ applied a comprehensive revision of its monetary policy operational framework in May 2012 and introduced three new instruments to inject liquidity in the economy. These instruments are; one-week and one-month securities repurchase agreements through quantitative bids arranged by the CBJ, the outright open market operations, and currency swaps. In addition, during this year, the CBJ first raised the interest rates on all monetary policy instruments by 175 basis points, mainly on the overnight deposit window facility. These decisions aimed at maintaining monetary stability through restraining inflationary pressures and supporting the Jordanian dinar competitiveness within the surrounding events around. As of August 2013, the Jordanian economy started to show positive developments in its fundamentals, an acceptable level of expected inflation accompanied by increase in the attractiveness of the Jordanian dinar’s denominated assets, and significant improvement in the current account reflecting a robust growth of foreign exchange reserves. Driven by these improvements, and to promote investments, economic growth and job creation, the CBJ started relaxing the previous interest rates. The CBJ decreased the interest rates levels on all monetary policy instruments four times in 2013 and 2014 by 125 basis points. Despite all these expansionary decisions, the banks’ response did not meet the envisaged levels. Therefore, the CBJ upgraded its monetary policy tools in a manner that helps banks to enhance their ability to effectively and efficiently manage their liquidity to adequately fulfill their operational needs, as well as, providing the increasing financing needs of different economic sectors. Accordingly, the CBJ applied the second revision of its monetary policy operational framework in February 2015. Within this revision, the CBJ introduced a key interest rate, “the CBJ main rate” to be the benchmark rate by which other policy rates will be determined. This measure aims at providing clear signals of the monetary policy stance and its orientation towards monetary and economic developments domestically and abroad, as well as, enhancing competition among banks. It also helps upgrading liquidity management instruments to enhance the banks’ ability to manage their liquidity in a highly effective and efficient manner.

The CBJ also reissued certificates of deposit in Jordanian dinar with different volumes and various maturities, aiming at directing banks’ liquidity towards achieving economic growth target through lending operations. In addition, in the


In the midst of high influx of Syrian refugees that started in 2011, the acceleration of the imports bill, especially energy, the high deficit in the government budget and current account, in addition to the lack of liquidity available for lending to all economic sectors, the kingdom faced huge economic pressures in 2012. As a result, the CBJ applied a comprehensive revision of its monetary policy operational framework in May 2012 and introduced three new instruments to inject liquidity in the economy. These instruments are; one-week and one-month securities repurchase agreements through quantitative bids arranged by the CBJ, the outright open market operations, and currency swaps. In addition, during this year, the CBJ first raised the interest rates on all monetary policy instruments by 175 basis points, mainly on the overnight deposit window facility. These decisions aimed at maintaining monetary stability through restraining inflationary pressures and supporting the Jordanian dinar competitiveness within the surrounding events around. As of August 2013, the Jordanian economy started to show positive developments in its fundamentals, an acceptable level of expected inflation accompanied by increase in the attractiveness of the Jordanian dinar’s denominated assets, and significant improvement in the current account reflecting a robust growth of foreign exchange reserves. Driven by these improvements, and to promote investments, economic growth and job creation, the CBJ started relaxing the previous interest rates. The CBJ decreased the interest rates levels on all monetary policy instruments four times in 2013 and 2014 by 125 basis points. Despite all these expansionary decisions, the banks’ response did not meet the envisaged levels. Therefore, the CBJ upgraded its monetary policy tools in a manner that helps banks to enhance their ability to effectively and efficiently manage their liquidity to adequately fulfill their operational needs, as well as, providing the increasing financing needs of different economic sectors. Accordingly, the CBJ applied the second revision of its monetary policy operational framework in February 2015. Within this revision, the CBJ introduced a key interest rate, “the CBJ main rate” to be the benchmark rate by which other policy rates will be determined. This measure aims at providing clear signals of the monetary policy stance and its orientation towards monetary and economic developments domestically and abroad, as well as, enhancing competition among banks. It also helps upgrading liquidity management instruments to enhance the banks’ ability to manage their liquidity in a highly effective and efficient manner.

The CBJ also reissued certificates of deposit in Jordanian dinar with different volumes and various maturities, aiming at directing banks’ liquidity towards achieving economic growth target through lending operations. In addition, in the


purpose of enhancing the ability of operating banks to manage their liquidity to fulfill their operational needs efficiently and effectively.

Based on the continuity of the positive developments of most monetary and economic indicators, and aiming at stimulating banks to expand lending to the private sector, the CBJ modified its monetary policy by decreasing its key interest rates twice in 2015 by 50 basis points for the main CBJ rate and by 125 basis points for overnight window facility. To ensure competitiveness and attractiveness of the Jordanian dinar for investors and to maintain monetary stability, meanwhile, keeping monitoring the ongoing global monetary policy changes, the CBJ started to raise interest rates on its monetary policy tools by the end of 2016. On December 2016, the CBJ raised the interest rates on its monetary policy instruments by 25 basis points, which was followed by another three times hikes in 2017 in which the CBJ increased the interest rates on all its monetary policy instruments by a total of 100 basis points for the increments in 2017. However, acknowledging the importance of small and medium enterprises in the Jordanian economy, especially in vital sectors, and to help providing the appropriate financing for these sectors, the CBJ decided to keep the refinancing program interest rates for these sectors unchanged. The program cover sectors like industry, tourism, agriculture, renewable energy and information technology, and its available fund is about 1.1 billion Jordanian dinar (equivalent to 5% of the direct facilities granted by the banks). The CBJ (in cooperation with international institutions) is also providing a bundle of incentives for licensed banks to support SMEs lending. The agreements signed by CBJ and the government with the international institutions for this purpose amounts to US $440 million.

4. Conclusion During its trajectory, the CBJ faced different economic and political challenges and many critical points, either on the local, regional or global level. In addressing these challenges, monetary policy played an essential role. The well-designed and implemented monetary policy is a fundamental factor for the kingdom to achieve sustainable growth and high welfare levels. Given the characteristics of the Jordanian economy as a small open economy with strong ties with external economies, the volume of these challenges enforced huge burden and hard situations to be managed by the CBJ. The monetary policy carried out by the CBJ showed a very high degree of flexibility and capability to deal with these extraordinary events efficiently and successfully. The several updates of the monetary policy instruments, objectives, and decisions to adapt with economic defiance included a wide spectrum that ranged from introducing the open market operations, switching to indirect monetary policy management, the inclusion of financial stability as an additional target for the CBJ and the introduction of the corridor system.


Appendix: Main Economic Indicators

Table (1): Interest rate structure

year weekly/monthly Repo

Overnight Deposit Window

Rate

overnight Repo

Rediscount rate

CBJ main interest Rate*

2012 4.25 4 4.75 5 - 2013 3.75 3.5 4.25 4.5 - 2014 3 2.75 4 4.25 - 2015 2.5 1.5 3.5 3.75 2.5 2016 2.75 1.75 3.5 3.75 2.75

Jun.2017 3.75 2.75 4.5 4.75 3.75 *: Effective since February 2015

Table (2): Inflation Rate

year 2012 2013 2014 2015 2016 Jan.–Jul. 2017

CPI 4.5 4.8 2.9 –0.9 –0.8 3.4

Chart (1): Interest rate structure


Appendix: Main Economic Indicators

Table (1): Interest rate structure

year weekly/monthly Repo

Overnight Deposit Window

Rate

overnight Repo

Rediscount rate

CBJ main interest Rate*

2012 4.25 4 4.75 5 - 2013 3.75 3.5 4.25 4.5 - 2014 3 2.75 4 4.25 - 2015 2.5 1.5 3.5 3.75 2.5 2016 2.75 1.75 3.5 3.75 2.75

Jun.2017 3.75 2.75 4.5 4.75 3.75 *: Effective since February 2015

Table (2): Inflation Rate

year 2012 2013 2014 2015 2016 Jan.–Jul. 2017

CPI 4.5 4.8 2.9 –0.9 –0.8 3.4

Chart (1): Interest rate structure


Table (3): Economic Growth Rate

year 2012 2013 2014 2015 2016 Projection 2017

GDP growth 2.7 2.8 3.1 2.2 2.0 2.3

t Chart (2): Annual Inflation Rate (CPI %)

-2

-1

0

1

2

3

4

5

6

2012 2013 2014 2015 2016 Jan.-Jul. 2017

CPI

0

0.5

1

1.5

2

2.5

3

3.5

2012 2013 2014 2015 2016 Projection2017

GDP growth

Chart (3): GDP Growth Rate (%)



The United Arab Emirates

Mr. Khalifa Ahmed Al Fahim Investment Manager

Central Bank of the UAE

Abu Dhabi, United Arab Emirates 15–16th November 2017


Monetary Policy Developments in

the United Arab Emirates 1. Introduction In an open economy, such as the UAE, where trade represents a large fraction of domestic production and consumption, the benefits of pegging the dirham to the US dollar have been substantial in terms of fostering UAE economic development. The main sources of income for the country, via exports, are priced in US dollar, and investment assets and income are mostly denominated in US dollar.

Historically, the fixed exchange rate peg to the US dollar has served the UAE well by providing a stable nominal anchor for monetary policy and the UAE economy resulting in a relatively stable price level for a significant portion of the fixed exchange rate regime’s history. Such stability has helped to insulate the main sources of revenues for the fiscal government from fluctuations in the exchange rate and has reduced operational, and transaction costs of managing UAE owned foreign assets. Indeed, thanks to the stability of the exchange rate peg, international trade and investment have progressively grown with a sizeable portion of current international transactions denominated in US dollars. At the same time, oil revenues have been a major source of revenues for fiscal policy, which has played an important role to handle potential business cycle de-synchronization with the US and ensure the healthy growth of the UAE non-energy economic activity. Sound fiscal and monetary policies are the underlying pillars for the stability of the exchange rate system as they are pre-requisites for the effectiveness of the fixed exchange rate regime.

The Central Bank of the United Arab Emirates (CBUAE) is responsible for the implementation of monetary policy and its main objective is to maintain a stable and convertible currency, where the AED is managed within a narrow band of AED/USD 3.6720–3.6730. The purpose of this paper is to review the current operational set up of the implementation of monetary policy in the UAE.

This paper is organized as follows: Section 1 is the introduction; Section 2 discusses the objectives of monetary policy in the UAE; Section 3 provides an overview of the broad framework currently in place; Section 4 lists the monetary policy tools available for managing liquidity in the domestic market; Section 6 conclusion.


Monetary Policy Developments in

the United Arab Emirates 1. Introduction In an open economy, such as the UAE, where trade represents a large fraction of domestic production and consumption, the benefits of pegging the dirham to the US dollar have been substantial in terms of fostering UAE economic development. The main sources of income for the country, via exports, are priced in US dollar, and investment assets and income are mostly denominated in US dollar.

Historically, the fixed exchange rate peg to the US dollar has served the UAE well by providing a stable nominal anchor for monetary policy and the UAE economy resulting in a relatively stable price level for a significant portion of the fixed exchange rate regime’s history. Such stability has helped to insulate the main sources of revenues for the fiscal government from fluctuations in the exchange rate and has reduced operational, and transaction costs of managing UAE owned foreign assets. Indeed, thanks to the stability of the exchange rate peg, international trade and investment have progressively grown with a sizeable portion of current international transactions denominated in US dollars. At the same time, oil revenues have been a major source of revenues for fiscal policy, which has played an important role to handle potential business cycle de-synchronization with the US and ensure the healthy growth of the UAE non-energy economic activity. Sound fiscal and monetary policies are the underlying pillars for the stability of the exchange rate system as they are pre-requisites for the effectiveness of the fixed exchange rate regime.

The Central Bank of the United Arab Emirates (CBUAE) is responsible for the implementation of monetary policy and its main objective is to maintain a stable and convertible currency, where the AED is managed within a narrow band of AED/USD 3.6720–3.6730. The purpose of this paper is to review the current operational set up of the implementation of monetary policy in the UAE.

This paper is organized as follows: Section 1 is the introduction; Section 2 discusses the objectives of monetary policy in the UAE; Section 3 provides an overview of the broad framework currently in place; Section 4 lists the monetary policy tools available for managing liquidity in the domestic market; Section 6 conclusion.


2. Monetary Policy Objectives Maintaining a stable and convertible currency is a key policy objective of the CBUAE. The exchange rate peg is longstanding and has been in place since 1980. The CBUAE operates the peg via FX window where AED is exchanged versus the USD at the rates of 3.6720/3.6730 to buy or sell USD, respectively. In addition, the CBUAE acts as the sole supplier of AED to UAE governments, selling AED at a fixed rate. The stability of the currency is backed by the reserves management policy, whereby the market value of balance of foreign reserves shall not, at any time, be less than 70% of value of the monetary base

Maintaining a fixed exchange rate regime imposes limitations on the operation of monetary policy. Given its peg to the US dollar, monetary policy has mirrored that of the US, and therefore, the CBUAE is required to move domestic short-term rates accordingly. More specifically, in the UAE, the current binding short-term interest rates are the floor rates applied to CBUAE’s Certificates of Deposit (CDs) Therefore, any move in the Federal Funds Target Rate is accommodated by a subsequent move in cut-off rates applied to CBUAE’s CDs. In other words, the CBUAE’s monetary policy implementation aims to ensure short-term rates are consistent with US rates while maintaining an adequate level of liquidity within the UAE banking system. 3. Monetary Policy Framework As a major commodity exporter, the UAE maintains a persistent current account surplus while the Federal government has little need to fund itself through debt issuance. Historical current account surpluses reflecting the UAE’s oil wealth has been reflected in the accumulation of foreign assets holding by the CBUAE, as illustrated in chart 1. Liquidity in the banking sector is managed through required reserves and issuance of the CBUAE’s Certificate of Deposits (CDs). This often implies a structural excess liquidity (i.e., more than is required for payment and settlement purposes) position within the UAE banking system particularly during periods of higher oil prices. In practice, the source of this excess liquidity is via the Abu Dhabi government through oil revenues, which accounts for more most of net AED purchases from the CBUAE. With Emirates level governments depositing funds with commercial banks, Abu Dhabi government purchases and sales of AED can have significant implications for the international reserves position at the central bank and the liquidity position of the UAE banking sector.


Given persistent structural excess liquidity, the CBUAE’s monetary operations are usually aimed at draining the bulk of the liquidity surplus from the UAE banking system by offering banks an auction process to invest in Certificates of Deposits issued by the Central Bank which are redeemable upon demand.

The CBUAE also offers a number of standing facilities to provide liquidity, both in dirham and dollar denominations. Table 1 below provides an overview of CBUAE’s standing facilities currently available to UAE banks.

Table (1): Liquidity Absorbing and Providing Instruments

AED Liquidity Absorbing Instruments AED Liquidity Providing Instruments

Certificates of Deposit (CDs) Repo and Early Redemption of CDs/ICDs

Islamic Certificates of Deposit (ICDs) USD/AED Swap Facility

Interim Marginal Lending Facility (IMLF)

Collateralized Murabaha Facility (CMF)

Chart (1): Central Bank of the UAE Balance Sheet (2010 – 2017)


Given persistent structural excess liquidity, the CBUAE’s monetary operations are usually aimed at draining the bulk of the liquidity surplus from the UAE banking system by offering banks an auction process to invest in Certificates of Deposits issued by the Central Bank which are redeemable upon demand.

The CBUAE also offers a number of standing facilities to provide liquidity, both in dirham and dollar denominations. Table 1 below provides an overview of CBUAE’s standing facilities currently available to UAE banks.

Table (1): Liquidity Absorbing and Providing Instruments

AED Liquidity Absorbing Instruments AED Liquidity Providing Instruments

Certificates of Deposit (CDs) Repo and Early Redemption of CDs/ICDs

Islamic Certificates of Deposit (ICDs) USD/AED Swap Facility

Interim Marginal Lending Facility (IMLF)

Collateralized Murabaha Facility (CMF)

Chart (1): Central Bank of the UAE Balance Sheet (2010 – 2017)


Within this framework, the CBUAE offers a band or ‘comfort zone’ within which short-term interest rates may fluctuate. The ceiling of this band may be considered the interest rate charged on the (IMLF) for conventional banks, or the profit rate applied to CMF for Islamic banks. The one-week CDs rate being the shortest tenor offering the lowest rate constitutes a floor to the band. With daily CDs issuance and the option of early redemption, the CDs facility typically acts as a de-facto deposit facility.

With a passive approach to monetary policy implementation along with a persistent current account surplus, the current framework effectively allows for a persistent excess structural liquidity. As a result, short-term interbank rates fall towards the lower bound of the interest rate band, the one-week CDs rate. In other words, a bank holding excess liquidity may either deposit excess liquidity at the CBUAE via the CDs program or lend to the market at a market-determined rate hovering around the CDs rates.

Chart (2): UAE’s Standing Facilities and Money Market rates

As evidenced by Chart 2, excess structural liquidity within the UAE banking system suggests that the one-week CDs rate acts as a de-facto policy rate. It is the one-week CDs rate, which is binding under the current policy framework. For example, if the one-week CDs rate were to shift up 25 basis points, this would be reflected in the interbank market, as banks could either lend to each other at the higher rate or deposit excess funds with the CBUAE at the new CD rate.

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 Aug-17

CBUAE Repo Rate 1w EIBOR 1 week CBUAE CD Rate IMLF


This framework is ineffective a “floor system”. There is, however, an inherent trade-off implied in the maintenance of a floor system. In particular, excess structural liquidity gives banks little incentive to lend/borrow from the interbank market at short maturities. In other words, a liquid interbank market is unlikely to develop with the continuation of the current system of CDs issuance offered by the Central Bank where CDs are redeemable at banks’ requests. 4. Tools Utilized in Achieving Monetary Policy Objectives

The following subsections outline the AED liquidity absorbing instruments and AED liquidity providing instruments, and explain how the CBUAE manages the level of liquidity in the banking system.

4.1. AED Liquidity-Absorbing Instruments

CDs and ICDs CDs are issued by the CBUAE and constitute direct, general, unconditional and unsubordinated obligations of the CBUAE. The system was essentially demand-driven as banks with excess liquidity can invest their surplus funds in CDs of varying maturities. Therefore, the CD is the instrument used by the CBUAE to absorb excess liquidity in the banking sector, though it is at the discretion of the banks whether to purchase CDs. The CDs program began in the late 1980s and went through two transformations, once in 1994 and the second one in 2007 when auctions were introduced. The auction-based CDs issuance system became effective in November 2007. The auctions are conducted on a fixed rate full-allotment basis. They are issued for a wide range of maturities, 1 week, and 1, 2, 3, 6, 9, and 12 months, all on a daily basis. Banks submit their bids with required maturities and amounts on the day of the auction to the CBUAE treasury department. The minimum amount is 1 million, and any increment is in the multiples of 1 million. In November 2010, the Islamic CDs (ICDs) were introduced by the CBUAE. The ICDs is structured based on a Murabahah concept where the underlying assets are Sharia-compliant. Offered tenors include 1 week, 1, 2, 3, 6, 9 and 12 months, all issued on a daily basis through auction. Bids must be in the form of profit rate (clean of commodity cost).


This framework is ineffective a “floor system”. There is, however, an inherent trade-off implied in the maintenance of a floor system. In particular, excess structural liquidity gives banks little incentive to lend/borrow from the interbank market at short maturities. In other words, a liquid interbank market is unlikely to develop with the continuation of the current system of CDs issuance offered by the Central Bank where CDs are redeemable at banks’ requests. 4. Tools Utilized in Achieving Monetary Policy Objectives

The following subsections outline the AED liquidity absorbing instruments and AED liquidity providing instruments, and explain how the CBUAE manages the level of liquidity in the banking system.

4.1. AED Liquidity-Absorbing Instruments

CDs and ICDs CDs are issued by the CBUAE and constitute direct, general, unconditional and unsubordinated obligations of the CBUAE. The system was essentially demand-driven as banks with excess liquidity can invest their surplus funds in CDs of varying maturities. Therefore, the CD is the instrument used by the CBUAE to absorb excess liquidity in the banking sector, though it is at the discretion of the banks whether to purchase CDs. The CDs program began in the late 1980s and went through two transformations, once in 1994 and the second one in 2007 when auctions were introduced. The auction-based CDs issuance system became effective in November 2007. The auctions are conducted on a fixed rate full-allotment basis. They are issued for a wide range of maturities, 1 week, and 1, 2, 3, 6, 9, and 12 months, all on a daily basis. Banks submit their bids with required maturities and amounts on the day of the auction to the CBUAE treasury department. The minimum amount is 1 million, and any increment is in the multiples of 1 million. In November 2010, the Islamic CDs (ICDs) were introduced by the CBUAE. The ICDs is structured based on a Murabahah concept where the underlying assets are Sharia-compliant. Offered tenors include 1 week, 1, 2, 3, 6, 9 and 12 months, all issued on a daily basis through auction. Bids must be in the form of profit rate (clean of commodity cost).


The total CDs outstanding at the end of September 2017 was approximately AED 97 billion, 28% of which is ICDs. All CDs are treated as High-Quality Liquid Asset (HQLA). 4.2 AED Liquidity Absorbing Instruments Repo of CDs Banks can repo their CDs with the CBUAE to access liquidity. The repo term offered by the CBUAE is up to 3 months. Overnight Repo rate is fixed while Term Repo rates are priced by the CBUAE on demand by banks requesting them, in line with the security being repo-ed and the term being requested. All repo agreements between the CBUAE and the commercial banks are usually based on same day settlement basis. Early Redemption of CDs and ICDs Banks are also allowed to redeem CDs before maturity. They shall contact the CBUAE to determine the redemption price of the said CDs. The redemption price is set by the CBUAE according to the remaining life and prevailing market interest rates plus or minus a margin. The settlement is made on a T+1 basis. Also, ICDs are also allowed to be redeemed early either in full or in part. Dollar/Dirham Swaps Dollar/dirham swaps are a mode of injecting dirham liquidity in case a bank needs liquidity. Swap arrangements involve a simultaneous sale and forward purchase of Dollars against the purchase/forward sale of equivalent dirham amount for a fixed term at specified forward rates. Swap terms range from 1 week, 1, 3, 6, 9 and 12 months. The Dollar/dirham swap facility is at the discretion of banks to overcome temporary shortages of dirham liquidity.


Interim Marginal Lending Facility (IMLF) The IMLF is a liquidity supporting facility. The interest rate charged on the IMLF is set at the CBUAE Repo rate plus 100 basis points. This rate is set sufficiently high to encourage banks to attempt to exhaust other options, such as the interbank market, before approaching the CBUAE for liquidity. For a bank holding sufficient eligible collateral, the IMLF rate constitutes a theoretical maximum interest rate at which such a bank may access overnight AED liquidity within the UAE.

Drawing on IMLF funds is open to all banks which are licensed to operate in the UAE and are required to maintain reserves with the CBUAE and are direct participants in the UAE Funds Transfer System. IMLF transactions are based upon a Triparty Repurchase Agreement, the Triparty Agent, will undertake the collateral management and CBUAE will handle the fund’s transfer via its Real-Time Gross Settlement System (“UAEFTS”). Collateralized Murabaha Facility (CMF) Following the successful implementation of the IMLF, the CBUAE has worked to implement a Sharia-compliant version, known as the Collateralized Murabaha Facility (CMF), which was formally introduced in March 2015. This Sharia-compliant facility also accepts the CBUAE’s ICDs as collateral to provide dirham liquidity to Islamic Banks, which facility introduced in 2011.

5. Summary

The key policy objectives of the CBUAE is to maintain a stable and convertible currency AED. Historically, the AED peg to the US Dollar has served the UAE well, with relatively stable growth and moderate inflation. The exchange rate regime benefits the UAE by reducing transaction costs and foreign exchange risks for UAE firms and minimizing volatility caused by capital flows. The long-term benefits of the current regime are self-evident in


Interim Marginal Lending Facility (IMLF) The IMLF is a liquidity supporting facility. The interest rate charged on the IMLF is set at the CBUAE Repo rate plus 100 basis points. This rate is set sufficiently high to encourage banks to attempt to exhaust other options, such as the interbank market, before approaching the CBUAE for liquidity. For a bank holding sufficient eligible collateral, the IMLF rate constitutes a theoretical maximum interest rate at which such a bank may access overnight AED liquidity within the UAE.

Drawing on IMLF funds is open to all banks which are licensed to operate in the UAE and are required to maintain reserves with the CBUAE and are direct participants in the UAE Funds Transfer System. IMLF transactions are based upon a Triparty Repurchase Agreement, the Triparty Agent, will undertake the collateral management and CBUAE will handle the fund’s transfer via its Real-Time Gross Settlement System (“UAEFTS”). Collateralized Murabaha Facility (CMF) Following the successful implementation of the IMLF, the CBUAE has worked to implement a Sharia-compliant version, known as the Collateralized Murabaha Facility (CMF), which was formally introduced in March 2015. This Sharia-compliant facility also accepts the CBUAE’s ICDs as collateral to provide dirham liquidity to Islamic Banks, which facility introduced in 2011.

5. Summary

The key policy objectives of the CBUAE is to maintain a stable and convertible currency AED. Historically, the AED peg to the US Dollar has served the UAE well, with relatively stable growth and moderate inflation. The exchange rate regime benefits the UAE by reducing transaction costs and foreign exchange risks for UAE firms and minimizing volatility caused by capital flows. The long-term benefits of the current regime are self-evident in


the ongoing diversification of the UAE economy, as the stability of the exchange rate peg has encouraged the investment necessary to achieve such ends.

Monitoring the liquidity stance within the banking sector is another important element in implementing our monetary policy objectives as it gives the CBUAE early warning signals of developments in the local dirham market. In this regard, the CBUAE’s role is to provide banks operating in the UAE with a number of alternative monetary tools to assist them in their daily liquidity management exercise. In this regard, the CBUAE has introduced new monetary tools, including new standing facilities, as part of its monetary management framework in addition to its CDs.

To sum up, the monetary policy framework aims at maintaining a stable and convertible currency, while ensuring an adequate level of liquidity within the UAE banking system through the various available monetary instruments. The CBUAE will continue to maintain a ‘comfort zone’ for interest rates through the usage of the various existing instruments while introducing new facilities as necessary to manage liquidity in the banking system in line with priorities for non-energy growth while safeguarding the stability of the exchange rate system.



The Kingdom of Bahrain

Prepared by H.E. Sheikh Salman Bin Isa Al- Khalifa

Executive Director of Banking Operations

Presented by: Hesa Abdulla Al Sada

Director of Banking Services




The Kingdom of Bahrain

Prepared by H.E. Sheikh Salman Bin Isa Al- Khalifa

Executive Director of Banking Operations

Presented by: Hesa Abdulla Al Sada

Director of Banking Services





Liquidity Management in Islamic Banks and its Implications

For Monetary Policy

1. Introduction The Kingdom of Bahrain is a financial center in the Middle East region for conventional and Islamic finance. The banking sector, which consists of both conventional and Islamic banks, has made a noteworthy contribution to Bahrain’s emergence and continued success as a financial center. As at end-2015, the total assets of the banking sector were about US$ 185 billion, six times more than the Gross Domestic Product (GDP). As at end-September 2017, the conventional banking sector included 23 retail banks, 56 wholesale banks, two specialized banks and 36 representative offices of overseas banks. The Islamic banking sector consisted of six retail banks and 18 wholesale banks. Bahrain has a leading position in the Middle East region for offering Sharia-compliant innovative financial instruments, institutions and a regulatory framework. For example, in 2001, in the Middle East, Sharia-compliant Sukuk-al-ijara, Islamic leasing (ijara) Securities (Sukuk) pioneered by the Central Bank of Bahrain (CBB), on behalf of the Government. One of the main objectives of the CBB in implementing the integrated RTGS-SSS Systems in 2007 was to develop the securities market (for both, conventional and Islamic) by offering government securities in scripless form at the primary market and making these securities available in the secondary market for trading, liquidity management (including intraday) and monetary policy operations. The CBB has continued its efforts to develop Islamic banking products and services by: (i) Issuing market-oriented investment instruments (such as Sukuk-al-

ijara and Sukuk-al-salam) in the SSS System, on a regular basis. (ii) Providing the required infrastructure and tools such as intraday credit

(IDC) in the RTGS System and Sharia-compliant Islamic Sukuk Liquidity Instrument (ISLI) and Wakalah, for Islamic banks to easily manage their liquidity and for the CBB to offer standing facilities, to inject/absorb excess liquidity with Islamic retail banks.


(iii) Introducing easy to use instruments such as Wakalah that specifically cater to Islamic banks for their liquidity management.

(iv) Paving the way for Islamic banks themselves to grow by offering safe and secured Islamic products/instruments.

Islamic banks offer banking products and services in Bahraini dinars or any other currency, in compliance with Sharia principles, to residents and non-residents. Such Islamic banking products include restricted and unrestricted investment accounts, Murabaha, Ijara, Mudaraba, Musharaka, Al Salam and Istitsna’a, syndications and other structures used in conventional finance, which has been modified to comply with Sharia principles. In Bahrain, conventional banks as well can offer Islamic banking products and services within their Islamic windows that comply with the respective Sharia governance requirements. Islamic banking has shown significant growth, and the total assets of Islamic banks amounted to US$ 27 billion by end of April 2017. This showed a 14 times increase when compared to US$ 1.9 billion in 2000. Accordingly, the market share of Islamic banks also increased from 1.8% of total banking assets in 2000 to 14.8% as at the end of May 2017.

116,

686

109,

285

108,

814

103,

036

104,

586

12.1%13.2% 13.3% 13.2%

14.8%

Wholesale Bank Assets Retail Bank Assets Islamic Bank Assets as % of Total

Chart 1: Bahrain Banking Sector Asset Composition


(iii) Introducing easy to use instruments such as Wakalah that specifically cater to Islamic banks for their liquidity management.

(iv) Paving the way for Islamic banks themselves to grow by offering safe and secured Islamic products/instruments.

Islamic banks offer banking products and services in Bahraini dinars or any other currency, in compliance with Sharia principles, to residents and non-residents. Such Islamic banking products include restricted and unrestricted investment accounts, Murabaha, Ijara, Mudaraba, Musharaka, Al Salam and Istitsna’a, syndications and other structures used in conventional finance, which has been modified to comply with Sharia principles. In Bahrain, conventional banks as well can offer Islamic banking products and services within their Islamic windows that comply with the respective Sharia governance requirements. Islamic banking has shown significant growth, and the total assets of Islamic banks amounted to US$ 27 billion by end of April 2017. This showed a 14 times increase when compared to US$ 1.9 billion in 2000. Accordingly, the market share of Islamic banks also increased from 1.8% of total banking assets in 2000 to 14.8% as at the end of May 2017.

116,

686

109,

285

108,

814

103,

036

104,

586

12.1%13.2% 13.3% 13.2%

14.8%

Wholesale Bank Assets Retail Bank Assets Islamic Bank Assets as % of Total

Chart 1: Bahrain Banking Sector Asset Composition


Within the Sharia framework, Islamic banking needs to be carried out in compliance with the principles of Islamic Sharia. Therefore, the success of Islamic banking largely depends on the availability of Sharia-compliant financial instruments and the required infrastructure that: (i) Cater to the growing demand for Islamic finance (which can basically

serve needs more or less similar to those fulfilled by conventional instruments) ; and

(ii) Facilitate liquidity management at all levels, i.e. bank, interbank and central bank level.

It is the responsibility of each bank to have liquid assets and access to funding sources to meet its obligations as they fall due.1 Sound and efficient liquidity management of banks in their day-to-day operations has a special importance for the central bank in carrying out its statutory roles to ensure effective monetary policy operations and smooth functioning of the payment systems as well as financial system stability. The objective of this paper is to review liquidity management in Islamic banks from the monetary policy standpoint. Accordingly, the paper mainly elaborates the liquidity instruments which are made available by the CBB for Islamic banks under its monetary policy operations to manage their liquidity in normal times and its implications on monetary policy.

2. Liquidity management in Islamic banks

Like conventional banks, Islamic banks are faced with the challenge in liquidity management of eliminating any prospective liquidity risk.2 Insufficient liquidity can lead a bank to quickly borrow against its medium and long-term financial assets at an unfavourable rate or sell its assets, even at a loss. Such liquidity problems have the potential to create instability,

It is the responsibility of the bank’s Board of Directors and management to ensure that the bank has sufficient liquidity to meet its obligations as they fall due." LM-A1.2.1. Rulebook of Central Bank of Bahrain-Volume 2. Islamic bank licensees must maintain sufficient liquid assets to meet their obligations as they fall due in the normal course of their business. Islamic bank licensees must agree a liquidity management policy with the CBB." LR-2.5.8. Rulebook of Central Bank of Bahrain-Volume 2.

The definition of liquidity risk is “Liquidity risk is the potential loss to IIFS arising from their inability either to meet their obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses” according to paragraph 81 of IFSB-1.


particularly in the payment system, where difficulty in meeting payment obligations can occur. On the other hand, having excessive liquidity is also costly to the bank. Accordingly, banks are faced with the challenges of efficient and effective liquidity management and maintaining an appropriate balance between insufficient and excessive liquidity. Having considered the prospective constraints of Islamic banks, the CBB has paid special emphasis to create a level playing field between conventional and Islamic banks to operate in the interbank market and the payment systems (such as RTGS-SSS Systems and retail payment systems) and to use the available tools for liquidity management. The liquidity management tools available for Islamic banks by the CBB are: (i) Buy and sell Bahraini dinars against US dollars; (ii) Buy and sell short-term such as Sukuk-al-ijara; (iii) invest excess liquidity in the Sharia-compliant Wakalah standing

facility; (iv) obtain intraday credit (IDC) in the RTGS system; and (v) borrow to cover liquidity shortage using Islamic Sukuk Liquidity

Instrument (ISLI). 3. Bahrain’s monetary policy framework

3.1 Monetary policy Objectives Under Article 3 of the Central Bank of Bahrain and Financial Institutions Law 2006 (the CBB Law)3 one of the objectives of the Central Bank of Bahrain (CBB) is to set and implement the monetary, credit and other financial sector policies. According to Article 4 (2) of the CBB Law, the CBB has a duty and power to draw and implement the appropriate monetary policies to achieve the Kingdom’s general economic goals and maintain the stability of the Bahraini currency and the monetary system. Accordingly, the ultimate targets of the monetary policy are to support sustainable economic growth while ensuring the stability of the Bahraini dinar and the monetary system.

The Central Bank of Bahrain and the Financial Institutions Law 2006 (CBB Law) was promulgated on 6 September 2006 with the issuance of Legislative Decree No 64 of 2006, which repealed Legislative Decree No 23 of 1973, establishing the Bahrain Monetary Agency (BMA), and Legislative Decree No 17 of 1987 regarding insurance companies and organisations.


particularly in the payment system, where difficulty in meeting payment obligations can occur. On the other hand, having excessive liquidity is also costly to the bank. Accordingly, banks are faced with the challenges of efficient and effective liquidity management and maintaining an appropriate balance between insufficient and excessive liquidity. Having considered the prospective constraints of Islamic banks, the CBB has paid special emphasis to create a level playing field between conventional and Islamic banks to operate in the interbank market and the payment systems (such as RTGS-SSS Systems and retail payment systems) and to use the available tools for liquidity management. The liquidity management tools available for Islamic banks by the CBB are: (i) Buy and sell Bahraini dinars against US dollars; (ii) Buy and sell short-term such as Sukuk-al-ijara; (iii) invest excess liquidity in the Sharia-compliant Wakalah standing

facility; (iv) obtain intraday credit (IDC) in the RTGS system; and (v) borrow to cover liquidity shortage using Islamic Sukuk Liquidity

Instrument (ISLI). 3. Bahrain’s monetary policy framework

3.1 Monetary policy Objectives Under Article 3 of the Central Bank of Bahrain and Financial Institutions Law 2006 (the CBB Law)3 one of the objectives of the Central Bank of Bahrain (CBB) is to set and implement the monetary, credit and other financial sector policies. According to Article 4 (2) of the CBB Law, the CBB has a duty and power to draw and implement the appropriate monetary policies to achieve the Kingdom’s general economic goals and maintain the stability of the Bahraini currency and the monetary system. Accordingly, the ultimate targets of the monetary policy are to support sustainable economic growth while ensuring the stability of the Bahraini dinar and the monetary system.

The Central Bank of Bahrain and the Financial Institutions Law 2006 (CBB Law) was promulgated on 6 September 2006 with the issuance of Legislative Decree No 64 of 2006, which repealed Legislative Decree No 23 of 1973, establishing the Bahrain Monetary Agency (BMA), and Legislative Decree No 17 of 1987 regarding insurance companies and organisations.


The CBB Monetary Policy Committee (MPC) that meets on a weekly basis closely monitors local/ international economic and financial developments; liquidity conditions (vital to the effective transmission of monetary policy instruments towards achieving the ultimate targets) and makes recommendations to the CBB Board/senior management on appropriate policy measures (including monetary policy instruments and the interest/profit rates on government debt securities and facilities offered by the CBB) to ensure the achievement of the operational targets of the monetary policy.

3.2.1 Pegged exchange rate: the nominal anchor for monetary policy

Bahrain is a country with an open economy with no restrictions on capital movements, foreign exchange, foreign trade or foreign investment. Since 2001, Bahrain pegged its currency, the Bahraini dinar to the US dollar (1 Bahraini dinar is equal to 2.659 US dollars4) and this exchange rate peg provides an anchor for monetary policy (see Chart 2). As per Article 19 (b) of the CBB Law, the amount of foreign exchange reserves permanently maintained by the CBB in normal times should not be less than 100% of the value of the currency in circulation. This pegged exchange rate regime has helped the Bahraini dinar to remain stable, supporting sound macroeconomic management, which is vital to ensuring investor confidence in the smooth and effective functioning of financial markets, and thereby further improving Bahrain’s status as a financial center in the region. The credibility gained by the exchange rate peg has complemented monetary policy implementation.

4 According to Royal Decree No 48 issued in December 2001.


3.2.2 Interest rate policy

Since Bahrain has free capital movement and the pegged exchange rate regime, the CBB closely aligns the CBB key policy interest rate on the one-week deposit facility to Fed funds rate. However, the CBB has resorted to fixing its policy rates with a suitable differential in favor of the Bahraini dinar to manage Bahraini dinar liquidity in the domestic market (Please see Chart 3). The CBB key interest rate guides the interest/return rates for its standing facilities provided to retail banks (including Islamic banks), short-term interest rates in the Bahrain money market and the deposit and lending rates that banks offer to their customers. The CBB policy interest rates prevailing on 31st August 2017 are given in Table 1.

Chart 2: Bahraini dinar Exchange Rate

Chart 3: CBB Policy Interest Rates


3.2.2 Interest rate policy

Since Bahrain has free capital movement and the pegged exchange rate regime, the CBB closely aligns the CBB key policy interest rate on the one-week deposit facility to Fed funds rate. However, the CBB has resorted to fixing its policy rates with a suitable differential in favor of the Bahraini dinar to manage Bahraini dinar liquidity in the domestic market (Please see Chart 3). The CBB key interest rate guides the interest/return rates for its standing facilities provided to retail banks (including Islamic banks), short-term interest rates in the Bahrain money market and the deposit and lending rates that banks offer to their customers. The CBB policy interest rates prevailing on 31st August 2017 are given in Table 1.

Chart 2: Bahraini dinar Exchange Rate

Chart 3: CBB Policy Interest Rates


Table 1:The CBB policy interest rates as at 31st August 2017

No. Facility Interest rate % 1 CBB key policy rate 1.5 2 One-week deposit rate 1.5 3 One-week Wakalah rate 1.5 4 Overnight deposit rate 1.25 5 Overnight Wakalah rate 1.25 6 One-month deposit rate 2.15 7 Overnight lending rate 3.25 8 Overnight rate for borrowing against government

treasury bills/ Sukuk-al-ijara 3.25

3.2.3 Price stability

The maintenance of price stability in the economy is vital to promote high levels of economic growth (see Chart 4) and economic welfare while avoiding any adverse impact of prolonged inflation or deflation. Low inflation and a stable currency with the pegged exchange rate are important long-term features of the Bahraini economy that support a stable business environment and high levels of both domestic and foreign investment. Historically, inflation has not been a concern as the level of inflation has been stable for long periods and fluctuations have been moderate.

Source: Central Informatics Organization.

Chart 4: Real GDP Growth


4. Liquidity management tools available from the CBB under its monetary policy for Islamic banks to manage their liquidity Having considered the Islamic banks’ need for Sharia-compliant liquidity management instrument (that also have a bearing on the liquidity level of the Islamic banking sector), the CBB has made available the following liquidity management tools in conducting monetary policy operations: (i) Sell or buy Bahraini dinars against US dollar to/from the CBB:

The CBB’s monetary policy accommodates the banks’ Bahraini dinar liquidity needs mainly by buying/selling US dollars at the official buy and sell exchange rates. These US dollar purchases/sales have a bearing on the liquidity positions at the clearing accounts of banks at the CBB and thereby on the monetary base (MO).

(ii) Sharia-compliant Wakalah standing facility to manage excess liquidity: In the absence of standing facilities similar to those of conventional deposit facilities, Islamic retail banks had a high level of excess liquidity parked at their clearing accounts in the CBB at zero profit. The Wakalah-one week facility was introduced in March 2015 to help Islamic retail banks to manage their excess liquidity. The one-week Wakalah (offered every Tuesday) became popular among Islamic banks as a short-term liquidity management tool to manage their excess liquidity. Having considered the high demand, for the overnight facility, the CBB decided to offer overnight Wakalah facility on business days in June 2017. All licensed Islamic retail banks are eligible to access this facility and the contract used in this facility is based on the International Islamic Financial Market (IIFM) Master Agency (Wakalah) Agreement, which is recognized and used by the Islamic banks operating in Bahrain. The agreement appoints the CBB as the Wakil and the Islamic banks as the Muwakkil. The structure is provided for a segregated pool of assets that are defined in terms of size, yield, and composition on a regular basis. The pool of assets consists of defined Sharia-compliant Islamic Sukuks and Bahraini dinars in the form of cash. The profit rates offered are approximately equivalent to the CBB policy rates to conventional retail banks. Each retail Islamic bank intending to use the Wakalah facility signs a Wakalah agreement, which appoints the CBB as an agent (Wakil) to invest in a portfolio of eligible securities and cash on behalf of the Islamic bank (Muwakil).


4. Liquidity management tools available from the CBB under its monetary policy for Islamic banks to manage their liquidity Having considered the Islamic banks’ need for Sharia-compliant liquidity management instrument (that also have a bearing on the liquidity level of the Islamic banking sector), the CBB has made available the following liquidity management tools in conducting monetary policy operations: (i) Sell or buy Bahraini dinars against US dollar to/from the CBB:

The CBB’s monetary policy accommodates the banks’ Bahraini dinar liquidity needs mainly by buying/selling US dollars at the official buy and sell exchange rates. These US dollar purchases/sales have a bearing on the liquidity positions at the clearing accounts of banks at the CBB and thereby on the monetary base (MO).

(ii) Sharia-compliant Wakalah standing facility to manage excess liquidity: In the absence of standing facilities similar to those of conventional deposit facilities, Islamic retail banks had a high level of excess liquidity parked at their clearing accounts in the CBB at zero profit. The Wakalah-one week facility was introduced in March 2015 to help Islamic retail banks to manage their excess liquidity. The one-week Wakalah (offered every Tuesday) became popular among Islamic banks as a short-term liquidity management tool to manage their excess liquidity. Having considered the high demand, for the overnight facility, the CBB decided to offer overnight Wakalah facility on business days in June 2017. All licensed Islamic retail banks are eligible to access this facility and the contract used in this facility is based on the International Islamic Financial Market (IIFM) Master Agency (Wakalah) Agreement, which is recognized and used by the Islamic banks operating in Bahrain. The agreement appoints the CBB as the Wakil and the Islamic banks as the Muwakkil. The structure is provided for a segregated pool of assets that are defined in terms of size, yield, and composition on a regular basis. The pool of assets consists of defined Sharia-compliant Islamic Sukuks and Bahraini dinars in the form of cash. The profit rates offered are approximately equivalent to the CBB policy rates to conventional retail banks. Each retail Islamic bank intending to use the Wakalah facility signs a Wakalah agreement, which appoints the CBB as an agent (Wakil) to invest in a portfolio of eligible securities and cash on behalf of the Islamic bank (Muwakil).


The CBB (Wakil) announces the Wakil’s offer on its pages on Reuters and Bloomberg. The offer contains the issue/maturity date and the expected profit rate.

Retail Islamic banks wishing to place their excess liquidity at the CBB, will send to the CBB an acceptance to the offer via SWIFT. The communication should include the placement value, the profit rate and the issue and maturity dates. The CBB invests these funds in the investment portfolio (which contains Islamic Sukuks and Bahraini dinars in the form of cash) in advance. On the maturity date, the CBB returns to the Islamic bank (Muwakkil) the funds, plus the earned profit, less the administration fees (BD1 per transaction).

Chart 5: Structure of Wakalah

Chart 6: Structure of Wakalah


(iii) Islamic Sukuk Liquidity Instrument (ISLI): The ISLI was introduced by the CBB in 2008 to help Islamic banks (that are direct members of the RTGS-SSS Systems) to obtain liquidity against their short and long-term Sukuk-al-ijara holdings (denominated in Bahraini dinars) in their securities accounts at the SSS System. An ISLI transaction (one-week) involves: (a) Dual level (first and second level) of matching and

confirmation with three parties : • Sukuk owner (the Islamic bank that needs liquidity); • Intermediary bank (the market marker); • The CBB, which will offer the bank the required

liquidity. (b) Three separate Sukuk sale and purchase transactions :

• Bank A (seller/Sukuk owner): sells the Sukuk to Bank B (market maker) and receives the liquidity needed (both banks should be direct members of the RTGS-SSS Systems.

• Bank B (market maker): sells the Sukuk to the CBB, the second purchaser, which offers the required liquidity;

• The CBB (that offers liquidity) at maturity, sells back the Sukuk to Bank A (the first seller and owner of the Sukuk).

(c) Two separate agreements: • A repurchase agreement between the direct member

that sells the Islamic securities to the CBB through the market-maker ; and

• An undertaking or promise of the direct member (that sold the Islamic securities) to buy back the Islamic securities from the CBB at the end of the repo period.

(iv) Short-term ijara Sukuk and Sukuk-al-salam:

The CBB issues the following short-term government debt securities via auctions in the SSS System, as per the issuance calendar published in advance in the CBB page at the Bloomberg and Reuters. The government debt securities issuances also have supported liquidity management for Islamic banks.


(iii) Islamic Sukuk Liquidity Instrument (ISLI): The ISLI was introduced by the CBB in 2008 to help Islamic banks (that are direct members of the RTGS-SSS Systems) to obtain liquidity against their short and long-term Sukuk-al-ijara holdings (denominated in Bahraini dinars) in their securities accounts at the SSS System. An ISLI transaction (one-week) involves: (a) Dual level (first and second level) of matching and

confirmation with three parties : • Sukuk owner (the Islamic bank that needs liquidity); • Intermediary bank (the market marker); • The CBB, which will offer the bank the required

liquidity. (b) Three separate Sukuk sale and purchase transactions :

• Bank A (seller/Sukuk owner): sells the Sukuk to Bank B (market maker) and receives the liquidity needed (both banks should be direct members of the RTGS-SSS Systems.

• Bank B (market maker): sells the Sukuk to the CBB, the second purchaser, which offers the required liquidity;

• The CBB (that offers liquidity) at maturity, sells back the Sukuk to Bank A (the first seller and owner of the Sukuk).

(c) Two separate agreements: • A repurchase agreement between the direct member

that sells the Islamic securities to the CBB through the market-maker ; and

• An undertaking or promise of the direct member (that sold the Islamic securities) to buy back the Islamic securities from the CBB at the end of the repo period.

(iv) Short-term ijara Sukuk and Sukuk-al-salam:

The CBB issues the following short-term government debt securities via auctions in the SSS System, as per the issuance calendar published in advance in the CBB page at the Bloomberg and Reuters. The government debt securities issuances also have supported liquidity management for Islamic banks.


(a) Short-term Sukuk-al-salam (non-tradable) securities that represent a commodity (residue gas) owned by the government and issued to finance development projects, on a monthly basis, with a three-month maturity; and

(b) Short-term Sukuk-al-ijara (tradable) sale and lease back securities that represent assets owned by the government and issued on a monthly basis, with a six-month maturity.

(v) Intraday credit facility (IDC) available to Islamic banks in the

RTGS System against their tradable Islamic securities holdings (Sukuk-al-ijara) in the SSS System. Since all Islamic retail banks are members of the RTGS and SSS Systems, they are eligible to get automated IDC (by providing a one-time standing instruction to the CBB, which specify the type of Islamic securities to be used and the amount) at a zero cost, to manage liquidity efficiently during RTGS-SSS System operating hours.

(vi) Unremunerated reserves that the Islamic retail banks have to maintain with the CBB. All Islamic banks must maintain a minimum cash reserve balance with the CBB, set as a ratio of their total non-bank Bahraini dinar deposits, whether placed by way of call or unrestricted investment accounts (or similar), as well as taken through the issuance of Bahrain dinar denominated Islamic investment certificates5. Currently, all Islamic retail banks are required to maintain, daily, a 5% of their customer (resident and non-resident) Bahraini dinar non-bank deposits. The reserve requirement is not considered as an active monetary policy instrument for day-to-day liquidity management, and its main purpose is to address structural liquidity issues.

5. Key issues and challenges

The CBB’s monetary policy, which operates in line with a nominal anchor of the exchange rate peg, mainly aims to ensure an appropriate level of liquidity in the banking sector. Islamic banks as well as conventional banks monitor mismatches of short-term liabilities with their long-term liabilities and manage any prospective mismatches by managing their liquidity. The

5 LR-2.5.10 of the Rulebook of Central Bank of Bahrain, Volume 2.


retail banks, including Islamic banks, maintain their Bahraini dinar liquidity in their settlement accounts at the RTGS System during its operating hours and thereafter in their clearing accounts at the BKS System, (the CBB’s core banking system). The balances in the clearing accounts are swept into the RTGS System at the beginning of the day and are used by banks (conventional and Islamic) to settle their interbank transactions (including money market lending/borrowing) as well as their customer transactions in the RTGS System during business hours. Towards the end of the day, balances in the settlement accounts in the RTGS System are swept out to their respective clearing accounts. The balances in the clearing accounts are not remunerated. Therefore, banks that get excess balances in these clearing accounts largely lend in the interbank money market. Banks that experience liquidity shortages also largely rely on the interbank money market, that operates very liquid interest-based borrowings. Islamic banks have to use Sharia-compliant liquid borrowing product/instrument to borrow in the interbank market. One of the key issues is the availability of a flexible and liquid Islamic interbank market of sufficient scale for these instruments to meet the demand of Islamic banks. Creating a dedicated market would not always result in the required market depth. One of the challenges is to bring more and more Sharia-compliant instruments and infrastructure including master agreements that could be used by Islamic as well as conventional banks into the interbank money market. Another challenge is the regulatory requirement for Islamic banks to meet gradual implementation of the Liquidity Coverage Ratio (LCR)6 requirements of the Basel Accords. Having considered the absence of a Sharia-compliant CBB deposit standing facility for Islamic banks and the need to give access to a greater range of zero-risk-weighted assets, in March 2015, the CBB introduced a Wakalah facility, a Level 1 asset according to Basel definitions. Furthermore, the introduction of one week and overnight Wakalah facilities provided another liquidity management tool for the CBB to conduct its monetary policy with the Islamic banks. Accordingly, since 2015, Islamic banks have participated continuously in Wakalah, and their participation increased to 7% of the total value outstanding under deposit standing facilities in 2016.

6 The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, 2013


retail banks, including Islamic banks, maintain their Bahraini dinar liquidity in their settlement accounts at the RTGS System during its operating hours and thereafter in their clearing accounts at the BKS System, (the CBB’s core banking system). The balances in the clearing accounts are swept into the RTGS System at the beginning of the day and are used by banks (conventional and Islamic) to settle their interbank transactions (including money market lending/borrowing) as well as their customer transactions in the RTGS System during business hours. Towards the end of the day, balances in the settlement accounts in the RTGS System are swept out to their respective clearing accounts. The balances in the clearing accounts are not remunerated. Therefore, banks that get excess balances in these clearing accounts largely lend in the interbank money market. Banks that experience liquidity shortages also largely rely on the interbank money market, that operates very liquid interest-based borrowings. Islamic banks have to use Sharia-compliant liquid borrowing product/instrument to borrow in the interbank market. One of the key issues is the availability of a flexible and liquid Islamic interbank market of sufficient scale for these instruments to meet the demand of Islamic banks. Creating a dedicated market would not always result in the required market depth. One of the challenges is to bring more and more Sharia-compliant instruments and infrastructure including master agreements that could be used by Islamic as well as conventional banks into the interbank money market. Another challenge is the regulatory requirement for Islamic banks to meet gradual implementation of the Liquidity Coverage Ratio (LCR)6 requirements of the Basel Accords. Having considered the absence of a Sharia-compliant CBB deposit standing facility for Islamic banks and the need to give access to a greater range of zero-risk-weighted assets, in March 2015, the CBB introduced a Wakalah facility, a Level 1 asset according to Basel definitions. Furthermore, the introduction of one week and overnight Wakalah facilities provided another liquidity management tool for the CBB to conduct its monetary policy with the Islamic banks. Accordingly, since 2015, Islamic banks have participated continuously in Wakalah, and their participation increased to 7% of the total value outstanding under deposit standing facilities in 2016.

6 The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, 2013


Table 5: Outstanding balances of CBB deposit/wakalah facilities

(BD million)

Date Total BD Deposits

Total Wakalah

BD Settlement of USD Sale

31 Dec. 2013 696 - (7)

31 Dec. 2014 873 - (9)

31 Dec. 2015 608 18 (20)

31 Dec. 2016 464 33 (15)

31 Aug. 2017 735 42 20 The CBB key policy interest is the most important monetary policy instrument. The CBB’s liquidity management tools are geared to ensure that short-term interbank money market rates move close to the CBB key policy rate. Accordingly, the CBB sets its policy rates and requirements relating to liquidity management tools with the aim of influencing retail banks’ short-term borrowings from deposits at the CBB; and thereby to influence the size of retail banks’ balances/reserve money7. The one-week deposit and Wakalah rates are maintained at the same level of CBB key policy rate, while overnight deposit rate and Wakalah rates are set 25 basis points (bps) less than the key policy rate. The overnight lending (BD Secured) and ISLI rates are set at 175 bps above the key policy rate. On one hand, the liquidity management decisions of Islamic banks have a bearing on the effectiveness of the monetary policy. On the other hand, the Wakalah deposits of Islamic banks corresponds to securities used for them by the CBB during the period. Accordingly, Wakalah deposits have a bearing on the CBB assets. It is noteworthy that Sukuk plays an active role as an important liquidity management tool but the depth, and breadth of its secondary market needs to be developed. Despite the availability of Sharia-compliant tradable Islamic securities and instruments such as ISLI in the SSS System and the listing of tradable Sukuk that Bahrain Bourse offers, the secondary market of Sukuk seems illiquid. The failure in meeting liquidity needs is due to a number of factors: a generally underdeveloped secondary market, the preference to keep Sukuk holdings to maturity and the lack of user-friendly mechanism/structure.

Reserves refer to retail banks’ deposits with the CBB that are most liquid assets used for interbank payment systems.


6. Conclusion

Bahrain, as an Islamic financial center in the region, is geared to promoting the growth of Islamic finance in numerous ways to cater for increasing investor demand for Sharia-compliant financial products and services. The CBB has taken the lead in addressing the challenges faced by the Islamic banks and introduced Sharia-compliant Islamic securities, paving the way for Islamic banks to introduce Sharia-compliant financial instruments and banking products/services. The CBB has created a level playing field between Islamic and conventional in its liquidity management tools for banks and its payment infrastructure. Furthermore, the CBB has sought in its CBB regulatory requirements to ensure that licensed Islamic banks follow: (i) The Islamic Sharia principles, standards and guidance notes of the

Islamic Financial Services Board and operate under the Sharia framework ; and

(ii) International best practices and standards applied to conventional financial institutions ; and

(iii) Guiding principles on the conduct of business for institutions offering Islamic financial services.

Having considered this challenge, the CBB has introduced Sharia-compliant liquidity management tools such as ISLI and Wakalah, for Islamic banks to use in their liquidity management via the same infrastructure used by conventional banks. Islamic banks as a sector are still faced with challenges to evolve by having more liquid instruments and to easily deal with domestic as well as international financial markets. The magnitude of the challenge in liquidity risk management depends on a number of factors including the following: (i) Easy access to a wide array of Sharia-compliant, easy to use, liquid

instruments (to place funds or raise funds) where necessary to efficiently manage liquidity to the satisfaction of Islamic banks in the domestic as well as international financial markets;

(ii) Availability of a flexible and liquid interbank market of a sufficient scale for these instruments to meet the demand of Islamic banks;

(iii) Availability of a flexible and liquid Islamic secondary market of sufficient scale for Sharia-compliant liquidity management instruments;

(iv) Availability of adequate Sharia-compliant liquidity management instruments from the central bank; and

(v) Fair access to interbank payment and securities settlement systems with intraday liquidity management instruments against Islamic securities.


6. Conclusion

Bahrain, as an Islamic financial center in the region, is geared to promoting the growth of Islamic finance in numerous ways to cater for increasing investor demand for Sharia-compliant financial products and services. The CBB has taken the lead in addressing the challenges faced by the Islamic banks and introduced Sharia-compliant Islamic securities, paving the way for Islamic banks to introduce Sharia-compliant financial instruments and banking products/services. The CBB has created a level playing field between Islamic and conventional in its liquidity management tools for banks and its payment infrastructure. Furthermore, the CBB has sought in its CBB regulatory requirements to ensure that licensed Islamic banks follow: (i) The Islamic Sharia principles, standards and guidance notes of the

Islamic Financial Services Board and operate under the Sharia framework ; and

(ii) International best practices and standards applied to conventional financial institutions ; and

(iii) Guiding principles on the conduct of business for institutions offering Islamic financial services.

Having considered this challenge, the CBB has introduced Sharia-compliant liquidity management tools such as ISLI and Wakalah, for Islamic banks to use in their liquidity management via the same infrastructure used by conventional banks. Islamic banks as a sector are still faced with challenges to evolve by having more liquid instruments and to easily deal with domestic as well as international financial markets. The magnitude of the challenge in liquidity risk management depends on a number of factors including the following: (i) Easy access to a wide array of Sharia-compliant, easy to use, liquid

instruments (to place funds or raise funds) where necessary to efficiently manage liquidity to the satisfaction of Islamic banks in the domestic as well as international financial markets;

(ii) Availability of a flexible and liquid interbank market of a sufficient scale for these instruments to meet the demand of Islamic banks;

(iii) Availability of a flexible and liquid Islamic secondary market of sufficient scale for Sharia-compliant liquidity management instruments;

(iv) Availability of adequate Sharia-compliant liquidity management instruments from the central bank; and

(v) Fair access to interbank payment and securities settlement systems with intraday liquidity management instruments against Islamic securities.



The Republic of Tunisia

Mrs. Rym A.Kolsi

Director of the Monetary Policy Strategy Central Bank of Tunisia



39

CONDUCTING MONETARY POLICY IN TURBULENT TIMES THE CASE OF TUNISIA

BACKGROUND Internal conditions, combined with external shocks, including the recession in the Euro Zone, have posed many challenges for the business climate in Tunisia.

The successful completion of Tunisia’s political transition, as reflected in the building of credible democratic institutions, was widely recognized at the international level, through the award of the 2015 Nobel Peace Prize to the Tunisian National Dialogue Quartet for its decisive contribution to this process. However, at the same time, economic activity was impacted in 2015 by the slowdown of tourism, remittances, and investment sector due to internal conditions.

Aware of these difficulties, the government is engaged in a five-year economic program (2016–2020) to build a strategy conducive to macroeconomic and financial stability with more inclusive growth, enhanced efficiency, job creation and strengthened economic resilience.

Six years after the 2011 revolution, the Tunisian economy is still evolving in a challenging environment that has resulted in deepening twin deficits due to low economic growth. The growth rate was just 1% in 2016 compared to 1.1% a year earlier, not enough to curb unemployment especially among high graduate young people.

1. DEALING WITH AN ECONOMIC SITUATION CAPTURED UNDER DEEP MACROECONOMIC IMBALANCES

1.1 A constraining fiscal deficit that does not let much room to a fiscal space Prior to the Revolution, the budget deficit was under control at less than 3% of GDP on average over 2000–2010, and public debt was mastered thanks to efforts made to keep it down to around 40% of GDP in 2010. After the Revolution, and even though the pace of fiscal consolidation was affected by the increased spending, efforts have been made to ensure a fiscal adjustment. To this end, the authorities have embarked on an ambitious and wide-ranging structural reform program encompassing civil service reform; tax policy and tax administration reforms; energy subsidy reform; pension system; public finance management; and public investment framework. The reform program also involves an anti-corruption framework with the setting up of a high-level constitutional body to fight corruption and promote good governance.


39

CONDUCTING MONETARY POLICY IN TURBULENT TIMES THE CASE OF TUNISIA

BACKGROUND Internal conditions, combined with external shocks, including the recession in the Euro Zone, have posed many challenges for the business climate in Tunisia.

The successful completion of Tunisia’s political transition, as reflected in the building of credible democratic institutions, was widely recognized at the international level, through the award of the 2015 Nobel Peace Prize to the Tunisian National Dialogue Quartet for its decisive contribution to this process. However, at the same time, economic activity was impacted in 2015 by the slowdown of tourism, remittances, and investment sector due to internal conditions.

Aware of these difficulties, the government is engaged in a five-year economic program (2016–2020) to build a strategy conducive to macroeconomic and financial stability with more inclusive growth, enhanced efficiency, job creation and strengthened economic resilience.

Six years after the 2011 revolution, the Tunisian economy is still evolving in a challenging environment that has resulted in deepening twin deficits due to low economic growth. The growth rate was just 1% in 2016 compared to 1.1% a year earlier, not enough to curb unemployment especially among high graduate young people.

1. DEALING WITH AN ECONOMIC SITUATION CAPTURED UNDER DEEP MACROECONOMIC IMBALANCES

1.1 A constraining fiscal deficit that does not let much room to a fiscal space Prior to the Revolution, the budget deficit was under control at less than 3% of GDP on average over 2000–2010, and public debt was mastered thanks to efforts made to keep it down to around 40% of GDP in 2010. After the Revolution, and even though the pace of fiscal consolidation was affected by the increased spending, efforts have been made to ensure a fiscal adjustment. To this end, the authorities have embarked on an ambitious and wide-ranging structural reform program encompassing civil service reform; tax policy and tax administration reforms; energy subsidy reform; pension system; public finance management; and public investment framework. The reform program also involves an anti-corruption framework with the setting up of a high-level constitutional body to fight corruption and promote good governance.


40

The weak economic growth (1.5% on average over 2011–2016) combined with the expansion of expenditure in the form of wages and subsidies exacerbated the fiscal deficit which stood in average at 5.3% of GDP over the six last years and is expected to reach 6.1% by 2017. Concurrently financing needs increased substantially and were partly offset by external resources but also by recourse to the domestic market to tap liquidity.

Chart 2: State budget financing (Gross flows in % of GDP)

Given the economic fundamentals challenges, the Tunisia’s sovereign rating was downgraded on several occasions, increasing the costs of external funding.

Chart 1: Budget balance and public debt (In % of GDP)


41

Table 1: Rating of Tunisia’s long-term sovereign risk in foreign currency R&I Fitch Moody’s S&P

2017 BB

Stable outlook

01 May 2017

B+

Stable Outlook

26 May 2017

B1

Negative Outlook

18 August 2017

2010 A–

Stable outlook

BBB

Stable Outlook

Baa2

Stable Outlook

BBB

Stable Outlook

2005 BBB+

Stable outlook

BBB

Stable Outlook

Baa2

Stable Outlook

BBB

Stable Outlook

2000 BBB+

Stable outlook

BBB–

Stable Outlook

Baa3

Positive Outlook

4 February 2000

BBB

Stable Outlook

21 March 2000

Source: BCT website.

0

100

200

300

400

500

600

700

2009 2010 2011 2012 2013 2014 2015 2016 2017

BTUN CDS USD (10years)

bpp Source: Bloomberg

Last data: October 26, 2017

Chart 3: Tunisia’s sovereign risk


41

Table 1: Rating of Tunisia’s long-term sovereign risk in foreign currency R&I Fitch Moody’s S&P

2017 BB

Stable outlook

01 May 2017

B+

Stable Outlook

26 May 2017

B1

Negative Outlook

18 August 2017

2010 A–

Stable outlook

BBB

Stable Outlook

Baa2

Stable Outlook

BBB

Stable Outlook

2005 BBB+

Stable outlook

BBB

Stable Outlook

Baa2

Stable Outlook

BBB

Stable Outlook

2000 BBB+

Stable outlook

BBB–

Stable Outlook

Baa3

Positive Outlook

4 February 2000

BBB

Stable Outlook

21 March 2000

Source: BCT website.

0

100

200

300

400

500

600

700

2009 2010 2011 2012 2013 2014 2015 2016 2017

BTUN CDS USD (10years)

bpp Source: Bloomberg

Last data: October 26, 2017

Chart 3: Tunisia’s sovereign risk


42

In addition, costs of domestic resources increased as a consequence of liquidity shortage at banks, on the one hand, and of the monetary policy tightening to cope with higher inflation expectation, on the other hand.

It is interesting to note that Tunisia’s vulnerability vis-à-vis abroad could be affected by a new orientation of the ECB’s policy which has already announced a significant reduction in its securities purchase program starting January 2018, which is seen as a gradual tightening of its monetary policy, seeing the inflation rate close to its target of 2%. This is likely to induce higher long-term interest rates.

1.2 A current account deficit widening under the weight of the trade deficit Aside the increase in fiscal deficit, the current account deficit widened gradually since the Revolution as a result of a faster pace in imports than in exports mainly. Important developments both at the international and the national levels were behind this situation. At the international level, the Euro Zone, Tunisia’s main trading partner was still having difficulty to find a way out of its economic marasmus; the growth rate posted 2.3% (yoy) in Q2-2017 and is expected to reach 2.2% (yoy) in 2017 and 1.8% in 2018 for the whole year.8 In addition, the

____________________ 8 ECB: Staff Macroeconomic projections for Euro Area. September 2017.

Chart 4: Public securities yield curve


geopolitical environment is still too fragile to support a recovery in external demand, especially from neighboring Libya.

Tunisia’s vulnerabilities towards abroad are also fueled by the upward trends in most commodities and energy prices.

At the domestic level, remaining difficulties in the extracting sectors of mining and oil, two of the most important export-oriented activities, along with a poor performance of the agricultural sector, led to a weak growth rate of just 1.9% (yoy) over the first half of 2017.

As a result of the above-mentioned, the current account deficit stood at high levels, exacerbating pressure on international reserves and foreign exchange market as well as on bank liquidity, and debt-to-GDP ratios picked up.

50

70

90

110

130

150

170

190

0

2000

4000

6000

8000

10000

12000

14000

16000Net assets in foreign currency (In MTD)

Net assets in foreign currency (In Million USD)

Days of import [RHS]

Source : BCT

Chart 5: Current account deficit in % of GDP

Chart 6: Trends in foreign exchange reserves


geopolitical environment is still too fragile to support a recovery in external demand, especially from neighboring Libya.

Tunisia’s vulnerabilities towards abroad are also fueled by the upward trends in most commodities and energy prices.

At the domestic level, remaining difficulties in the extracting sectors of mining and oil, two of the most important export-oriented activities, along with a poor performance of the agricultural sector, led to a weak growth rate of just 1.9% (yoy) over the first half of 2017.

As a result of the above-mentioned, the current account deficit stood at high levels, exacerbating pressure on international reserves and foreign exchange market as well as on bank liquidity, and debt-to-GDP ratios picked up.

50

70

90

110

130

150

170

190

0

2000

4000

6000

8000

10000

12000

14000

16000Net assets in foreign currency (In MTD)

Net assets in foreign currency (In Million USD)

Days of import [RHS]

Source : BCT

Chart 5: Current account deficit in % of GDP

Chart 6: Trends in foreign exchange reserves


1.3 Economic growth under severe strain

Since the outbreak of the Revolution, the economy has been stuck in a low-growth trap with low growth drivers leading to an important decrease in the potential, which was deeply affected by a slowdown in both capital and labor factors.

The break in activity in 2011 has deeply affected the potential of growth which set to a lower level since then. From 4.5% in Q1-2005, it stands at just 2% in Q2-2017. Consequently, the output gap remained negative and is expected to remain so for a while.

Chart 7: Trends in exchange rates of the Tunisian dinar

Chart 8: Trends in BCT interventions on the money market (in million

Tunisian dinars)


45

Internal conditions, in the aftermath of the Revolution, have affected confidence and therefore investment, notably FDI. Domestic demand was mainly supported by a resilient consumption, benefiting from a higher purchasing power in the aftermath of 2012, 2013, 2016 and 2017 due to wage increases in public and private non-agricultural sectors.

Concurrently growth rate posted just 1% in 2016 vs 1.1% in 2015. On average, it was roughly 1.5% over 2011-2016, not enough to curb unemployment and create wealth. Excluding agriculture, 2016 growth rate was 2% compared to nil in 2015.

-4

-2

0

2

4

6

8

-4

-2

0

2

4

6

8Output gap [RHS]GDP excl. AgriculturePotential growth

YoY Growth (%)

In %

Last data : Q2-2017.

05

10152025303540

2000

2002

2004

2006

2008

2010

2012

2014

2016

Unemployment rateHigh graduate unemployment rate

In

(*) Unemployment rates for 2017 are equal to thefirst half of the year average rates.

Chart 9: GDP growth (%) Chart 10: Trends in the potential of growth and in output gap

Chart 11: Contribution to GDP growth (%) Chart 12: Unemployment (%)


45

Internal conditions, in the aftermath of the Revolution, have affected confidence and therefore investment, notably FDI. Domestic demand was mainly supported by a resilient consumption, benefiting from a higher purchasing power in the aftermath of 2012, 2013, 2016 and 2017 due to wage increases in public and private non-agricultural sectors.

Concurrently growth rate posted just 1% in 2016 vs 1.1% in 2015. On average, it was roughly 1.5% over 2011-2016, not enough to curb unemployment and create wealth. Excluding agriculture, 2016 growth rate was 2% compared to nil in 2015.

-4

-2

0

2

4

6

8

-4

-2

0

2

4

6

8Output gap [RHS]GDP excl. AgriculturePotential growth

YoY Growth (%)

In %

Last data : Q2-2017.

05

10152025303540

2000

2002

2004

2006

2008

2010

2012

2014

2016

Unemployment rateHigh graduate unemployment rate

In

(*) Unemployment rates for 2017 are equal to thefirst half of the year average rates.

Chart 9: GDP growth (%) Chart 10: Trends in the potential of growth and in output gap

Chart 11: Contribution to GDP growth (%) Chart 12: Unemployment (%)


In fact, the agriculture and fishing sector was deeply affected by bad weather conditions and drought that kept its added value down to –8.1% compared to 12.5% in 2015 led by a super performance in olive oil production.

Also, the non-manufacturing industries did not perform well in 2016 (–1.9% vs –4.1% in 2015) given the remaining difficulties in the extractive sector of hydrocarbons and mining.

Growth was mainly led by manufacturing industries (+0.9% in 2016 vs 0.4% a year earlier) benefiting a gradual recovery in the Euro Zone. Also, market-services performed well (+2.7% vs –0.6% in 2015) especially for the tourism sector which was hard hit in 2015. But despite this improvement, the Tourism sector indicators did not yet reach their prior-to-the-Revolution levels.

Table 2: Tourism sector indicators

Unit 2010 2011 2012 2013 2014 2015 2016

Non-residents entries

Thousands 6902 4782 5950 6269 6069 4202 4526

Tourism revenue Million dinars

3523 2433 3175 3221 3626 2415 2373

Non-resident bed nights

Thousands 31833 16504 25762 25761 24833 11170 12784

Source: BCT and Tunisian Tourism Office

Chart 13: Tourism sector main indicators


2. CONDUCTING MONETARY POLICY IN A CHALLENGING ENVIRONMENT

After a relative easing, in 2016, inflation went up steadily. This was mainly due to the increase in foodstuff and manufactured product prices affected by the depreciation of the domestic currency for their imported component, on the one hand, and by the wage increases (2016 and 2017), for their processed component, on the other hand. Since the beginning of 2017, inflation embarked on an upward trend, reaching 5.7% in August; its highest level since April 2015.

Table 3: Trends in inflation by group of products and by regime of price setting (In %)

Description weight in% 2014 2015 2016

2016 (9

months)

2017 (9

months)

General index 100.0 4.9 4.9 3.7 3.6 5.0

By group of products

- Food products 28.1 5.4 5.2 2.6 2.6 4.7

• Unprocessed products 13.9 4.9 5.0 2.5 2.2 4.4

• Processed food products 14.2 6.0 5.4 2.8 2.9 5.0

- Manufactured products 36.6 5.2 4.8 3.6 3.4 5.7

- Services 35.3 4.2 4.6 4.9 4.8 4.6

By regime of price setting

- Unregulated prices 73.7 5.3 5.2 4.6 4.5 5.8

- Regulated prices 26.3 3.8 3.6 1.0 0.9 2.4

of which: energy 6.6 5.8 2.3 –1.0 –0.9 2.2

Sources: National Statistics Institute and BCT calculations

Despite its relative relaxation in 2016, when posting 3.7% yoy vs 4.9% in 2015, inflation increased gradually in 2017.

Anticipating this upraise, the Central Bank of Tunisia (BCT) increased at two occasions its key interest rate. A first 50 bp increase was decided at the end of April 2017 to 4.75% and was followed by a 25 bp increase late May 2017 to 5%. But despite these adjustments, real interest rates remained negative.


2. CONDUCTING MONETARY POLICY IN A CHALLENGING ENVIRONMENT

After a relative easing, in 2016, inflation went up steadily. This was mainly due to the increase in foodstuff and manufactured product prices affected by the depreciation of the domestic currency for their imported component, on the one hand, and by the wage increases (2016 and 2017), for their processed component, on the other hand. Since the beginning of 2017, inflation embarked on an upward trend, reaching 5.7% in August; its highest level since April 2015.

Table 3: Trends in inflation by group of products and by regime of price setting (In %)

Description weight in% 2014 2015 2016

2016 (9

months)

2017 (9

months)

General index 100.0 4.9 4.9 3.7 3.6 5.0

By group of products

- Food products 28.1 5.4 5.2 2.6 2.6 4.7

• Unprocessed products 13.9 4.9 5.0 2.5 2.2 4.4

• Processed food products 14.2 6.0 5.4 2.8 2.9 5.0

- Manufactured products 36.6 5.2 4.8 3.6 3.4 5.7

- Services 35.3 4.2 4.6 4.9 4.8 4.6

By regime of price setting

- Unregulated prices 73.7 5.3 5.2 4.6 4.5 5.8

- Regulated prices 26.3 3.8 3.6 1.0 0.9 2.4

of which: energy 6.6 5.8 2.3 –1.0 –0.9 2.2

Sources: National Statistics Institute and BCT calculations

Despite its relative relaxation in 2016, when posting 3.7% yoy vs 4.9% in 2015, inflation increased gradually in 2017.

Anticipating this upraise, the Central Bank of Tunisia (BCT) increased at two occasions its key interest rate. A first 50 bp increase was decided at the end of April 2017 to 4.75% and was followed by a 25 bp increase late May 2017 to 5%. But despite these adjustments, real interest rates remained negative.


Core inflation9 showed greater persistence, partly sustained by wage increases both in the public and the private sectors, combined with a notable depreciation of the dinar against the US dollar and the euro.

9 As measured by the annual changes of the consumer price index «excluding unprocessed foodstuff and administered prices’ products».

Chart 14: Monetary policy response to inflation

Chart 15: Trends in core inflation (annual averages in %)


2.1 A prudent monetary policy to cope with inflation

Basically, the Central Bank of Tunisia adopted in the aftermath of 2011 Revolution a prudent monetary policy aiming at coping with rising inflation. To do so, it embarked on an ambitious two-year-twinning program with Banque de France to set a Forecasting and Policy Analysis System (FPAS) (2011–2013).

Once renewed, the strategic framework of the monetary policy which was reinforced thanks to this transfer of know-how enabled the BCT to carry a proactive monetary policy while seeking to anchor inflation expectations.

Also, the operational framework of the monetary policy which benefited a second two-year-twinning program with Banque de France (2015–2017), was upgraded and shifted to the best international standards thanks to the reinforcement of market practices, the modernization of liquidity forecasting framework and the revisit of the regulatory framework governing monetary policy implementation.

2.2 How to deal with soaring banks’ refinancing needs?

During that period, the challenging matter for the Central Bank was to provide banks with liquidity, enough to finance the economy. The BCT experienced a full allotment strategy in the aftermath of the Revolution but starting 2012 it moved to a more neutral monetary policy meant to offset the effects of liquidity autonomous factors while inflation was on the rise.

Given the deterioration of the fundamentals of the economy and the substantial rise in twin deficits, refinancing needs exploded, becoming a matter of concern for the monetary authorities as BCT’s balance sheet widened tremendously.

However, despite the record volume of refinancing granted by the Central Bank to banks, in 2017, M3 money supply10 evolved in tandem with the activity; a major portion of refinancing being used to finance the current account deficit.

10 M3 money aggregate increased by 8.2% on average over H1-2017 vs 5.4 in H1-2016, while the financing to the economy evolved by 9.8% and 7.2% respectively (on average) over the same periods.


2.1 A prudent monetary policy to cope with inflation

Basically, the Central Bank of Tunisia adopted in the aftermath of 2011 Revolution a prudent monetary policy aiming at coping with rising inflation. To do so, it embarked on an ambitious two-year-twinning program with Banque de France to set a Forecasting and Policy Analysis System (FPAS) (2011–2013).

Once renewed, the strategic framework of the monetary policy which was reinforced thanks to this transfer of know-how enabled the BCT to carry a proactive monetary policy while seeking to anchor inflation expectations.

Also, the operational framework of the monetary policy which benefited a second two-year-twinning program with Banque de France (2015–2017), was upgraded and shifted to the best international standards thanks to the reinforcement of market practices, the modernization of liquidity forecasting framework and the revisit of the regulatory framework governing monetary policy implementation.

2.2 How to deal with soaring banks’ refinancing needs?

During that period, the challenging matter for the Central Bank was to provide banks with liquidity, enough to finance the economy. The BCT experienced a full allotment strategy in the aftermath of the Revolution but starting 2012 it moved to a more neutral monetary policy meant to offset the effects of liquidity autonomous factors while inflation was on the rise.

Given the deterioration of the fundamentals of the economy and the substantial rise in twin deficits, refinancing needs exploded, becoming a matter of concern for the monetary authorities as BCT’s balance sheet widened tremendously.

However, despite the record volume of refinancing granted by the Central Bank to banks, in 2017, M3 money supply10 evolved in tandem with the activity; a major portion of refinancing being used to finance the current account deficit.

10 M3 money aggregate increased by 8.2% on average over H1-2017 vs 5.4 in H1-2016, while the financing to the economy evolved by 9.8% and 7.2% respectively (on average) over the same periods.


Currently money market interest rates set closer to the 24 hour-lending facility rates than to the key official rate. This is mainly due to the restrictive effect of the external sector but also to other autonomous factors especially banknotes and coins in circulation which increased substantially since the Revolution as a consequence of a huge shadow economy among others11.

2.3 Issues regarding the effectiveness of the monetary policy

With the necessary hindsight, the transmission of the impulses of monetary policy, as a measure of the effectiveness of this policy, shows that given the adjustment delay of borrowing rates to the money market rate comprised between 2 and 4 months in most cases, costs of lending granted to both households and private businesses (all maturities included) increased subsequently to liquidity tightening, on the one hand, and to banks’ concern to preserve their interest margins, on the other hand.

11 In a study entitled « Shadow Economies All over the World » carried by the World Bank over the period 1999-2006, the shadow economy represents some 37.7% of Tunisian GDP.

Chart 16: Trends in inflation and in the M3-to-GDP gap


At the same time and in line with savings rate increase in April 201712, costs of resources at banks went up.

12 CF. BCT circular to banks n°2017-3 of 26 April 2017.

Chart 17: Trends in rates applied on new contracts of loans to household

(%)

Chart 18: Trends in rates applied on new contracts of loans to private

businesses (In %)

Chart 19: Trends in rates applied on new deposit contracts to households

(In %)

Chart 20: Trend in rates applied on new deposit contracts to private businesses

(In %)


At the same time and in line with savings rate increase in April 201712, costs of resources at banks went up.

12 CF. BCT circular to banks n°2017-3 of 26 April 2017.

Chart 17: Trends in rates applied on new contracts of loans to household

(%)

Chart 18: Trends in rates applied on new contracts of loans to private

businesses (In %)

Chart 19: Trends in rates applied on new deposit contracts to households

(In %)

Chart 20: Trend in rates applied on new deposit contracts to private businesses

(In %)


2.4 Reducing external imbalances

Under normal conditions, central banks ought to cope with economic slump by cutting their interest rates or by boosting demand by higher credit growth and Governments adopt a countercyclical policy by expanding expenditure. Nonetheless, Tunisia is facing a situation with low growth and high inflation; a virtual case of stagflation.

To deal with such a situation, a central bank owns two weapons: the key official rate and the exchange rate.

To preserve international reserves and facilitate external adjustment, the Central Bank of Tunisia committed to pursuing a more flexible exchange rate policy. To this end, deep operational changes were recently introduced in the foreign exchange market, including a foreign exchange auction system, to promote competitive bidding and contribute to greater exchange rate flexibility.

3. DEEP STRUCTURAL REFORMS UNDERWAY

In the transitional phase of the country, many structural reforms have been initiated. The Government recently approved a Development Plan for the period 2016–2020; it is a five-year vision backed to a new program supported by the IMF (EFF).

The Plan relies on three crucial packages concerning (i) monetary policy and financial sector; (ii) the fiscal policy; (iii) the business climate.

With regards to monetary policy and financial sector, major reforms were engaged and concerned mainly the amendment of the law on the statutes of the Central Bank of Tunisia and the banking law.

With the promulgation in 2016 of the new statutes of the Central Bank, the mission of the Issuing Institute has been clarified. The Central Bank is above all the guarantor of price stability. However, its other mission is to contribute to financial stability in order to support the Government’s work in achieving macroeconomic policies, promoting healthy and sustainable economic growth, and employment.

Thus, the central bank is responsible for setting the monetary policy and ensuring its implementation, implementing the exchange rate policy set by the Government, managing foreign exchange reserves, ensuring the proper functioning of the payment systems, supervising banks and financial institutions, issuing money, and assuming the role of financial adviser to the Government on all economic and financial matters.


In addition to the fact that the new statutes of the Central Bank have strengthened the governance of the Institution, by giving greater powers to the Board of Directors, they have instituted the mechanism of lender of last resort13, an essential component of the safety net aimed at ensuring financial stability, given that its other two components, namely the bank resolution mechanism and the deposit guarantee mechanism, were set up under the new banking law of 2016.

It is interesting to note that under the new banking law, a specific legal framework for the exercise of Islamic banking has been established; Also banks and financial institutions, practicing conventional finance, have been allowed to engage in Islamic banking.

Another highlight is the strengthening of the good governance of banks and financial institutions, in parallel with the strengthening of the power of the Central Bank in terms of prudential supervision.

In the area of monetary policy, and in the context of strengthening market practices, a new Central Bank circular on the implementation of monetary policy was published in early 2017. This text highlights the instruments and monetary policy operations of the Central Bank, as well as those initiated by the banks. The collateralization framework was also revisited to preserve the balance sheet of the Issuing Institute. Currently, banks are asked to present at least a portion of 40% in the form of public securities in counterpart of the refinancing they get from Central Bank. Also, a 25% haircut is applied on private claims in the interim of setting a new framework of corporate rating meant to give a better assessment of credit risks.

As for the fiscal policy reform14, it encompasses among others the energy subsidy reform by setting up a new automatic mechanism to adjust oil prices to international prices. This mechanism was activated in July 2016. The Government aimed to reduce substantially energy subsidies and better target low-income-people thanks to a direct financing.

The reform program also aims at setting a more inclusive and fair tax policy and a more-friendly administration.

13 In this framework, the BCT issued a new Circular relative to the Emergency Liquidity Assistance.


In addition to the fact that the new statutes of the Central Bank have strengthened the governance of the Institution, by giving greater powers to the Board of Directors, they have instituted the mechanism of lender of last resort13, an essential component of the safety net aimed at ensuring financial stability, given that its other two components, namely the bank resolution mechanism and the deposit guarantee mechanism, were set up under the new banking law of 2016.

It is interesting to note that under the new banking law, a specific legal framework for the exercise of Islamic banking has been established; Also banks and financial institutions, practicing conventional finance, have been allowed to engage in Islamic banking.

Another highlight is the strengthening of the good governance of banks and financial institutions, in parallel with the strengthening of the power of the Central Bank in terms of prudential supervision.

In the area of monetary policy, and in the context of strengthening market practices, a new Central Bank circular on the implementation of monetary policy was published in early 2017. This text highlights the instruments and monetary policy operations of the Central Bank, as well as those initiated by the banks. The collateralization framework was also revisited to preserve the balance sheet of the Issuing Institute. Currently, banks are asked to present at least a portion of 40% in the form of public securities in counterpart of the refinancing they get from Central Bank. Also, a 25% haircut is applied on private claims in the interim of setting a new framework of corporate rating meant to give a better assessment of credit risks.

As for the fiscal policy reform14, it encompasses among others the energy subsidy reform by setting up a new automatic mechanism to adjust oil prices to international prices. This mechanism was activated in July 2016. The Government aimed to reduce substantially energy subsidies and better target low-income-people thanks to a direct financing.

The reform program also aims at setting a more inclusive and fair tax policy and a more-friendly administration.

13 In this framework, the BCT issued a new Circular relative to the Emergency Liquidity Assistance.


Pension funds are also a matter of concern for the Government as their financial position weakened especially in the aftermath of the Revolution. A reflection has been conducted on the effective implementation of voluntary retirement programs, to achieve the wage bill target of 12% of GDP by 2020.

As for tax reform, the Organic Budget Law, submitted to the Assembly of People’s Representatives, will be adopted as soon as possible. It is also necessary to accelerate the work for the establishment of the database of families in need.

The Government is working to clean up the situation of State Owned Enterprises (SOE) deeply affected by the fallouts of the Revolution in the one hand and the accumulation of years of poor governance, on the other hand. In the financial sector, the recapitalization operation of the three public banks was implemented and a business model was set up to strengthen the financial soundness of these banks and improve their ratios.

The main reforms meant to improve the business climate concerned mainly the revisit of the investment Code and the promulgation of the Law governing the Public-Private Partnership.

Conclusion

Currently Tunisia has to cope with widening twin deficits, and this makes conducting monetary policy a difficult task. The fiscal policy was carried in a countercyclical manner mainly to stabilize the social climate, through wage increases and higher subsidies, despite weak growth rates, the fiscal space becomes narrower and this increases the vulnerabilities of the country as shown through soaring debt-to-GDP ratios.

Also, the downgrade of sovereign ratings made more costly recourse to external resources. Obviously, the Central Bank of Tunisia endowed by the Law to preserve price stability through its proactive monetary policy has the responsibility to face the adverse effects of the former expansionary fiscal policy on the one hand, and the new set of measures to be taken in the framework of Budget Law meant to increase taxes, on the other hand, by a further tightening of its monetary policy at the time that the economic recovery is still fragile. A challenging environment that would take time to be relaxed.



The Kingdom of Saudi Arabia

Dr. Fahad Al Shathri Deputy Governor for Research and International Affairs

Saudi Arabian Monetary Authority



Managing Liquidity in a Fixed Exchange Rate Regime

Recent Developments From Saudi Arabia

1. Abstract

Managing system-wide liquidity is a major task for central banks and monetary authorities. In the last two decades, liquidity management has become both more important and more challenging as many economies witnessed extended periods of liquidity challenges. In Saudi Arabia, the challenge is unusual due to the nature of the Saudi economy and its financial system, which is fiscally driven and where liquidity is to a large extent influenced by the fiscal stance of the government. This note shares how recent oil price developments impacted the liquidity of the Saudi financial system and the experience of the Saudi Arabian Monetary Authority (SAMA) in managing and dealing with system-wide liquidity tightening. It highlights the approach and tools used by SAMA in this regard, along with their impact on the system.

The Saudi Arabian Financial System: Overview and Characteristics

Saudi Arabia is a single commodity exporter that relies heavily on oil revenues and where growth rates are strongly linked to oil price developments. This makes its real sector exposed to oil market volatility, which could have negative spillovers on the financial system. Furthermore, government spending plays an important role as the engine for economic growth. Most sectors including financial markets are highly correlated with it.

The sharp drop in oil prices since mid-2014 has resulted in the deterioration of several macroeconomic indicators as reflected by an economic slowdown, budget deficits, current account deficits, and an increase in public debt levels. This, in turn, has led to the implementation of various fiscal consolidation measures and triggered a process of significant structural reforms. These macroeconomic developments have also had negative spillovers on the financial system in the form of increased capital market volatility, slower credit, and money supply growth rates, and liquidity tightening resulting in higher market interest rates.


Managing Liquidity in a Fixed Exchange Rate Regime

Recent Developments From Saudi Arabia

1. Abstract

Managing system-wide liquidity is a major task for central banks and monetary authorities. In the last two decades, liquidity management has become both more important and more challenging as many economies witnessed extended periods of liquidity challenges. In Saudi Arabia, the challenge is unusual due to the nature of the Saudi economy and its financial system, which is fiscally driven and where liquidity is to a large extent influenced by the fiscal stance of the government. This note shares how recent oil price developments impacted the liquidity of the Saudi financial system and the experience of the Saudi Arabian Monetary Authority (SAMA) in managing and dealing with system-wide liquidity tightening. It highlights the approach and tools used by SAMA in this regard, along with their impact on the system.

The Saudi Arabian Financial System: Overview and Characteristics

Saudi Arabia is a single commodity exporter that relies heavily on oil revenues and where growth rates are strongly linked to oil price developments. This makes its real sector exposed to oil market volatility, which could have negative spillovers on the financial system. Furthermore, government spending plays an important role as the engine for economic growth. Most sectors including financial markets are highly correlated with it.

The sharp drop in oil prices since mid-2014 has resulted in the deterioration of several macroeconomic indicators as reflected by an economic slowdown, budget deficits, current account deficits, and an increase in public debt levels. This, in turn, has led to the implementation of various fiscal consolidation measures and triggered a process of significant structural reforms. These macroeconomic developments have also had negative spillovers on the financial system in the form of increased capital market volatility, slower credit, and money supply growth rates, and liquidity tightening resulting in higher market interest rates.


Source: SAMA

The Role of Monetary Policy Monetary policy in Saudi Arabia is anchored in exchange rate policy as the Saudi Riyal is pegged to the USD. Such an arrangement, combined with the fact that Saudi Arabia maintains an open capital account, implies limited room for monetary policy to respond to macroeconomic developments to achieve certain monetary objectives such as a target inflation rate. In addition, while SAMA can use policy interest rates to some extent, it cannot rely on it solely to achieve monetary stability due to the weak transmission of policy rate to lending rates. Instead, the Saudi Arabian Monetary Authority (SAMA) uses a framework that targets system liquidity in order to smooth the changes to liquidity levels in the system that result for instance from changes in government spending. Consequently, SAMA developed a liquidity management toolkit for both monitoring and policy intervention purposes. This consists of the following:

Chart (1): Impact of Oil Prices on Several Macroeconomic and Financial Indicators


- Standing Facilities (Repo and Reverse Repo transactions)

- Statutory Reserve Requirements

- Deposit placement with the banking sector.

- Issuance of SAMA bills

- FX swaps

Moreover, SAMA is also mandated with preserving financial stability, which can support monetary policy and overcome some of its limitations. For example, changes to the Loan to Deposit Ratio (LDR) can ease some of the pressure on liquidity during stressful times. Loan to Value (LTV) is also another tool that can be used to mitigate the build-up of risk in the residential mortgage sector. In general, macroprudential policies can be used to counter the undesired outcomes of some of the blunt monetary policy tools.

Recent Liquidity Tightening Episodes and Policy Responses: In general, the financial system has been characterized by ample liquidity levels during the last decade. This was mainly due to several reasons including the historically low levels of 3 domestic interest rates, which moved in line with US interest rate levels due to the exchange rate arrangement. Furthermore, the high oil prices, up to mid-2014, resulted in a high level of government spending and injection of high amounts of liquidity in the system, for instance through new infrastructure projects. The high levels of liquidity were reflected by several indicators including an extended period of low levels of the Saudi Arabian Interbank Offer Rate (SAIBOR), high growth levels of money supply indicators, high credit growth rates, and sizable daily reverse repo transactions with SAMA.

After the drop in oil prices in the second half of 2014, liquidity issues started to emerge in the system. Continued low oil prices resulted in a significant government budget deficit, (which later led to the establishment of the fiscal balance program that aims to balance the budget by 2020). Importantly for system liquidity, the government initiated a local debt issuance program for which both banks and Autonomous Government Institutions (AGIs) subscribed. As banks redirected part of their liquidity towards holding the newly issued government bonds, this resulted in partially crowding out the private sector in parts of the credit market. Furthermore, the subscription of AGIs to those bonds was financed through the withdrawals of deposits in the banking system, and thereby, further tightening liquidity as reflected in net


- Standing Facilities (Repo and Reverse Repo transactions)

- Statutory Reserve Requirements

- Deposit placement with the banking sector.

- Issuance of SAMA bills

- FX swaps

Moreover, SAMA is also mandated with preserving financial stability, which can support monetary policy and overcome some of its limitations. For example, changes to the Loan to Deposit Ratio (LDR) can ease some of the pressure on liquidity during stressful times. Loan to Value (LTV) is also another tool that can be used to mitigate the build-up of risk in the residential mortgage sector. In general, macroprudential policies can be used to counter the undesired outcomes of some of the blunt monetary policy tools.

Recent Liquidity Tightening Episodes and Policy Responses: In general, the financial system has been characterized by ample liquidity levels during the last decade. This was mainly due to several reasons including the historically low levels of 3 domestic interest rates, which moved in line with US interest rate levels due to the exchange rate arrangement. Furthermore, the high oil prices, up to mid-2014, resulted in a high level of government spending and injection of high amounts of liquidity in the system, for instance through new infrastructure projects. The high levels of liquidity were reflected by several indicators including an extended period of low levels of the Saudi Arabian Interbank Offer Rate (SAIBOR), high growth levels of money supply indicators, high credit growth rates, and sizable daily reverse repo transactions with SAMA.

After the drop in oil prices in the second half of 2014, liquidity issues started to emerge in the system. Continued low oil prices resulted in a significant government budget deficit, (which later led to the establishment of the fiscal balance program that aims to balance the budget by 2020). Importantly for system liquidity, the government initiated a local debt issuance program for which both banks and Autonomous Government Institutions (AGIs) subscribed. As banks redirected part of their liquidity towards holding the newly issued government bonds, this resulted in partially crowding out the private sector in parts of the credit market. Furthermore, the subscription of AGIs to those bonds was financed through the withdrawals of deposits in the banking system, and thereby, further tightening liquidity as reflected in net


SAMA bill subscriptions and reverse repo rates. Consequently, the LDR moved up to its regulatory ceiling, money supply indicators dropped, and the SAIBOR kept increasing reflecting the changed market conditions (Figure 2). Therefore, a policy intervention was deemed necessary.

The policy response by SAMA operated in several areas. First, SAMA increased the ceiling for the LDR requirement from 85% to 90%. This was to ease the pressure on banks that were competing for deposits to reduce their LDRs below the guideline ceiling. The move helped in releasing the pressure on banks, and as a result, the SAIBOR stabilized temporarily. The change in the LDR, however, was not enough on its own and more was needed to tackle the roots of the issue.

The continued decrease in liquidity caused the SAIBOR to resume its upward trend, calling for a second round of intervention. This time, SAMA intervened by injecting about SAR 13 billion in deposit placements into the financial system, priced on the basis of banks’ own bids and maturity requests.

This move by SAMA was followed by a third round of policy measures as follows:

- Placement of about SAR 22 billion in deposits on behalf of government agencies that hold accounts at SAMA, to address the fact that credit growth at that time started to slow down.

- Introducing new tenors for the repo facility that included 7, 28, and 90 days, in addition to the existing overnight Repo facility. This provided an alternative source of funding and a tool for banks to manage liquidity on a longer than overnight basis.

- Reducing the aggregate ceiling of SAMA bills subscription from SAR 9 billion to SAR 3 billion. This was meant to redirect the liquidity invested in SAMA bills towards the financial system.

- Restructuring the governance framework for the SAIBOR to ensure it reflects market conditions. This was in line with the recommendations of the International Organization of Securities Commission (IOSCO) Principles for Financial Benchmarks (following the LIBOR scandal in London).

A bigger issue was trying to align monetary measures with fiscal measures to ensure complementarity. Given the importance of fiscal policies in Saudi Arabia, it is vital to coordinate fiscal measures with monetary objectives. Coordination took place regarding the government debt financing plans and their diversification (e.g., domestic vs. international debt issuance). This was essential to ensure the preservation of the capacity of the financial system to


finance large amounts of domestic debt, while still enjoying adequate levels of liquidity. In the absence of ongoing coordination, further local debt issuance may counteract monetary efforts to preserve liquidity in the system.

The measures have to date proven to be effective. Liquidity conditions significantly eased and the SAIBOR has decreased significantly since the introduction of the final round of measures in October 2016. The amount of average daily Net Reverse Repo transactions (i.e., the daily amount of Reverse Repo minus Repo transactions) returned to their trend. Similarly, the LDR has decreased, moving away from the guideline ceiling. Finally, other liquidity indicators such the Liquidity Coverage Ratio (LCR) have returned to their upward trend at levels significantly above their regulatory requirements.

Source: SAMA.

Table (1): Selected Liquidity Indicators

Indicators Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017

LCR 153.0% 150.8% 167.0% 195.9% 218.2% 210.5%

NSFR 123.0% 120.3% 121.0% 125.0% 122.3% 122.6%

LDR 82.4% 84.5% 84.2% 80.7% 81.5% 81.7%

Money Supply (M3) Growth 0.2% –0.3% –1.0% 1.8% –0.5% 2.3%

Source: SAMA

Chart (2): Impact of policy decisions on liquidity indicators


finance large amounts of domestic debt, while still enjoying adequate levels of liquidity. In the absence of ongoing coordination, further local debt issuance may counteract monetary efforts to preserve liquidity in the system.

The measures have to date proven to be effective. Liquidity conditions significantly eased and the SAIBOR has decreased significantly since the introduction of the final round of measures in October 2016. The amount of average daily Net Reverse Repo transactions (i.e., the daily amount of Reverse Repo minus Repo transactions) returned to their trend. Similarly, the LDR has decreased, moving away from the guideline ceiling. Finally, other liquidity indicators such the Liquidity Coverage Ratio (LCR) have returned to their upward trend at levels significantly above their regulatory requirements.

Source: SAMA.

Table (1): Selected Liquidity Indicators

Indicators Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017

LCR 153.0% 150.8% 167.0% 195.9% 218.2% 210.5%

NSFR 123.0% 120.3% 121.0% 125.0% 122.3% 122.6%

LDR 82.4% 84.5% 84.2% 80.7% 81.5% 81.7%

Money Supply (M3) Growth 0.2% –0.3% –1.0% 1.8% –0.5% 2.3%

Source: SAMA

Chart (2): Impact of policy decisions on liquidity indicators


Conclusion: Given the nature of the Saudi economy and its financial system, liquidity management is an important part of SAMA’s role in maintaining a stable monetary and financial system. With the recent macroeconomic developments, this role has become more vital than ever. Even though the Saudi banking system has long been characterized as a system with ample liquidity, the recent liquidity tightness shows how quickly liquidity conditions can weaken. In addition, it magnifies the need for more coordination between fiscal policy, public debt strategy, and monetary policy. Anchoring market expectations about economic and financial developments is a driving factor in ensuring stable movements in system liquidity. Moreover, it highlights the role macroprudential policy can play in terms of offering complementary measures in achieving adequate liquidity in the system. As a result, communication with the financial sector as well as with government agencies was made clearer and more transparent. Finally, government plans for future debt issuances were designed in accordance with financial developments and in coordination with SAMA.



The Republic of Sudan

Dr. El Mutasim Abdalla ElFaki Director General for Policies,

Research and Statistics Department Central Bank of Sudan




The Republic of Sudan

Dr. El Mutasim Abdalla ElFaki Director General for Policies,

Research and Statistics Department Central Bank of Sudan



Monetary Policy – The Case of Sudan

Preface Operating under a fully fledged Islamic system since 1983, Sudan’s economy offers an experience that enriches monetary policy literature in the Arab region, adds unique perspectives, and provides invaluable lessons. It demonstrates that Islamic monetary and financial systems can exhibit significant resilience against a global financial crisis by averting direct spillovers. However, they may be less effective in shielding against secondary effects as the crisis plagues the economies of important partner countries.

The fact that the Islamic financial securities operate under an equity base rather than a debt base, as is the case in the conventional financial system, has played a role in safeguarding the financial system in Sudan from the immediate spillover of the 2008 global financial crisis that left deep global scars. It is also true that being less integrated with the international financial system and markets has spared the country from hassles associated with the financial crisis.

It is intriguing that, while Islamic monetary policy has covered vast theoretical grounds, in practice, the policy toolkit hasn’t reach fruition, particularly with respect to adhockery instruments for dealing with global crisis and external shocks. Hence, there is space for improvement.

Context Sudan is a lower-middle income country15 experiencing difficult economic episodes due to exogenous shocks and global crises. During the 2008 global financial crisis, the Sudanese economy was spared from the direct crisis spillover and monetary policy remained largely intact. Hence unlike in other countries, no unconventional measures –such as quantities easing was necessary.

However, a political referendum in year 2011 led to the split of the country into two states with South Sudan forming a new independent country. The secession caused exogenous shock that led to large internal and external imbalances and left the monetary policy in distress. While, considerable portion of the national wealth has been forfeited (including 75% of the oil income, 65% of fiscal revenues, and over 80% of foreign exchange earnings), at least 3/4th of the population remained within erstwhile country, Sudan. Therefore, aggregate

15 World Bank Classification


Monetary Policy – The Case of Sudan

Preface Operating under a fully fledged Islamic system since 1983, Sudan’s economy offers an experience that enriches monetary policy literature in the Arab region, adds unique perspectives, and provides invaluable lessons. It demonstrates that Islamic monetary and financial systems can exhibit significant resilience against a global financial crisis by averting direct spillovers. However, they may be less effective in shielding against secondary effects as the crisis plagues the economies of important partner countries.

The fact that the Islamic financial securities operate under an equity base rather than a debt base, as is the case in the conventional financial system, has played a role in safeguarding the financial system in Sudan from the immediate spillover of the 2008 global financial crisis that left deep global scars. It is also true that being less integrated with the international financial system and markets has spared the country from hassles associated with the financial crisis.

It is intriguing that, while Islamic monetary policy has covered vast theoretical grounds, in practice, the policy toolkit hasn’t reach fruition, particularly with respect to adhockery instruments for dealing with global crisis and external shocks. Hence, there is space for improvement.

Context Sudan is a lower-middle income country15 experiencing difficult economic episodes due to exogenous shocks and global crises. During the 2008 global financial crisis, the Sudanese economy was spared from the direct crisis spillover and monetary policy remained largely intact. Hence unlike in other countries, no unconventional measures –such as quantities easing was necessary.

However, a political referendum in year 2011 led to the split of the country into two states with South Sudan forming a new independent country. The secession caused exogenous shock that led to large internal and external imbalances and left the monetary policy in distress. While, considerable portion of the national wealth has been forfeited (including 75% of the oil income, 65% of fiscal revenues, and over 80% of foreign exchange earnings), at least 3/4th of the population remained within erstwhile country, Sudan. Therefore, aggregate

15 World Bank Classification


expenditure remained sticky and difficult to shift downwardly in order to allow proper adjustment.

The economy could not immediately offset the revenues loss because there were several constraints:

Firstly: the sheer magnitude of the shock was irreparable over the short run because and conventional measures since developing new revenue sources take longer time.

Secondly: the country lacked access to any avenues of external financial support.

Thirdly: unilateral sanctions by the US and debt arrears to major creditors constrained the follow of external resources thus further complicating the situation.

While still coping with the major loss of revenues as the result of the secession, a double whammy hit. Being a net exporter of crude oil as well as importer of certain refined products, Sudan faced a dual shock:

✓ A supply side shock as the result of technological breakthrough in oil drilling in the US coastal areas; and

✓ A sluggish global demand due to cooling down economic activities in major trading partners in the industrial world.

The oil revenues shock and accommodative fiscal and monetary policies contributed to the depletion of the international reserves to a critical level beyond the standard safe level. Monetary policy frameworks, transmission mechanisms, and policy effectiveness became impaired and the once reasonably functioning fiscal/monetary policy coordination relapsed into an outright fiscal dominance due to massive monetization of the fiscal deficit as the government inherited sticky expenditures and depleting cash buffers. Consequently, vast buildup of excessive liquidity in the system fueled inflation and exerted high pressure on the Sudanese pound causing it to depreciate and the exchange rate regime (managed float system) to cease to function effectively.

Addressing the Crisis, outlook, and Risks Because Sudan is not yet fully financially developed, it is not well connected with the international financial markets. As such, the primary impact of the 2008 financial crisis was not immediately felt. Rather, it came with a time lag through an indirect channel where the demand for and prices of major Sudanese exports were depressed as the result of oil price shock and economic slowdown in the major trading partners in the developed world.


While the financial crisis reduced the demand for exportable goods produced by countries like Sudan, the food crisis increased the import bill thus lowering the foreign exchange reserves and exerting more pressure on the exchange rate in order to stabilize the exchange rate. The central bank intervened by selling foreign currencies. However, the impact of these interventions was limited because other supporting fiscal, monetary, and structural measures have not been in place.

• International oil prices dropped from its record high hovering around US$150 to less than $50 per barrel. Since the country is self-sufficient as net exporter of crude oil but also imports certain refined products such as gasoil, the crisis had both price effect as well as income effect on Sudan.

• Closely related, is the drop of significant amount of foreign exchange revenue stream Sudan used to earn from renting its refinery and pipeline facilities to the South.

This situation, prompted serious consciousness at the national level that led to the emergence of a series of economic reform plans – including the five-year economic recovery plan (2015–2019), which is targeting restoration of the economic growth (a minimum of 7% of GDP growth rate on average16) and stability. Monetary and financial stability targets are envisaged as a means for restoring economic stability and growth using inflation; price; and exchange rate stability as intermediate targets, and monetary aggregates (M1 and M2) as operational targets.

Table 1: Main Monetary Sector Indicators

Five Years Economic Plan (2015–2019)

2015 2016

(Targeted)

2016

(Actual) 2017 2018 2019

Money Supply 95,426.4 95,426.4 120,800.0 104,969.1 116,515.7 125,836.9

Money Supply Annual Growth

Rate % 10.0 10.0 29.0 10.0 11.0 8.0

Inflation Rate 12.6% 30.5% a single digit

Source: Five Year Economic Plan – Focal Point Evaluation Report 2016.

16 The Five Year Economic Plan (2015-2019) Document


While the financial crisis reduced the demand for exportable goods produced by countries like Sudan, the food crisis increased the import bill thus lowering the foreign exchange reserves and exerting more pressure on the exchange rate in order to stabilize the exchange rate. The central bank intervened by selling foreign currencies. However, the impact of these interventions was limited because other supporting fiscal, monetary, and structural measures have not been in place.

• International oil prices dropped from its record high hovering around US$150 to less than $50 per barrel. Since the country is self-sufficient as net exporter of crude oil but also imports certain refined products such as gasoil, the crisis had both price effect as well as income effect on Sudan.

• Closely related, is the drop of significant amount of foreign exchange revenue stream Sudan used to earn from renting its refinery and pipeline facilities to the South.

This situation, prompted serious consciousness at the national level that led to the emergence of a series of economic reform plans – including the five-year economic recovery plan (2015–2019), which is targeting restoration of the economic growth (a minimum of 7% of GDP growth rate on average16) and stability. Monetary and financial stability targets are envisaged as a means for restoring economic stability and growth using inflation; price; and exchange rate stability as intermediate targets, and monetary aggregates (M1 and M2) as operational targets.

Table 1: Main Monetary Sector Indicators

Five Years Economic Plan (2015–2019)

2015 2016

(Targeted)

2016

(Actual) 2017 2018 2019

Money Supply 95,426.4 95,426.4 120,800.0 104,969.1 116,515.7 125,836.9

Money Supply Annual Growth

Rate % 10.0 10.0 29.0 10.0 11.0 8.0

Inflation Rate 12.6% 30.5% a single digit

Source: Five Year Economic Plan – Focal Point Evaluation Report 2016.

16 The Five Year Economic Plan (2015-2019) Document


Monetary Transmission Mechanism Theoretically speaking, transmission of monetary policy in Sudan may take place through either of three channels: the exchange rate, the credit channel, or the interest rate.

First: Interest Rate Channel

Because the country operates fully under the Islamic doctrine which prohibits the use of all forms of Riba (usury), conventional anchors such as interest rates cannot be applied. Instead, Murabaha rate (markup on goods purchase contract); Musharaka rate (joint venture profit-sharing percentage) Ijaraha rate (leasing contract) Mudaraba rate (share of profits given to the financier) provide a close Sharia-compliant substitute that resembles the interest rate in the conventional system. As such, it offers a reasonable anchor for signaling central bank’s monetary policy intentions. For instance, raising the Murabaha rate would indicate tighter monetary policy, and vice versa. However, there are some limitations.

• While it is possible to issue literally large amount of debt-based securities in a conventional system, under the Islamic system security issuances is bound by underlying assets. Hence producing adequate supply of securities for large liquidity management purposes can be challenging.

• Since yield curves only earn people’s confidence overtime, in a nascent Islamic financial market, which is a typical characteristic of several Arab countries – Sudan included, essential market information for a mature functioning may not be readily available and may need to be developed.

In Sudan, not so often that CBOS used these rates to manage the liquidity. Murabaha contracts form the bulk of bank financing as they seem to enjoy wider popularity both by the banks and their customers. As such, it can be used for monetary policy purpose. However, each year CBOS provides an indicative-only floor in order to ensure that depositors find the offered rates of return attractive enough to mobilize savings to meet financing needs under the Murabaha mode of finance. On the other hand, CBOS does not interfere with the cost of financing and the commercial banks are free to charge their competitive rates.


Second: The Credit Channel • Since the liberalization of the economy in the early 1992, all forms of credit

rationing or quantitative controls are prohibited, and no quantitative measures are used to regulate the credit to the private sector. The only exception in this regard is a CBOS policy hint to the commercial banks to assign some (at least 12%) of their credit portfolios to the microfinance and social spending priorities with a view of helping to reduce poverty.

• Additionally, a ceiling is described for commercial banks’ holdings of government securities (Government Musharaka Certificates GMCs) in order to prevent crowding out of the private sector by the government.

Third: The Exchange Rate Channel CBOS applies a managed float exchange rate regime for more than a decade. CBOS daily monitors the actually applied exchange rates by all banks and exchange bureaus and calculates a weighted average. This average is then circulated to each commercial bank and authorized foreign exchange dealers in order for them to use as an indicative rate for determining the following-day’s rates. The banks are allowed a band around this average (currently ± 4%).

Required Reserve Ratio CBOS’s monetary policy mainstay tool is the required reserve ratio RRR. Each year, CBOS determines the appropriate level of liquidity in the economy that is consistent with given GDP growth and inflation rates. RRR is then used to sterilize the excess liquidity based on macro level indicators. The result is mixed. While RRR served well when setting the macro monetary indicators, it seems to be less effective in the day-to-day management of the liquidity hence there is need to supplement it with other tools. There is indication that RRR become ineffective in managing credit and lending where the banks’ excess reserves are large. Often RRR remains at the same level throughout the year. However, there are instances where CBOS opt to vary the RRR more frequently but the result did not give rise the continuation. Also, since RRR in Sudan is not numerated, the commercial banks consider it to be a costly tool.


Second: The Credit Channel • Since the liberalization of the economy in the early 1992, all forms of credit

rationing or quantitative controls are prohibited, and no quantitative measures are used to regulate the credit to the private sector. The only exception in this regard is a CBOS policy hint to the commercial banks to assign some (at least 12%) of their credit portfolios to the microfinance and social spending priorities with a view of helping to reduce poverty.

• Additionally, a ceiling is described for commercial banks’ holdings of government securities (Government Musharaka Certificates GMCs) in order to prevent crowding out of the private sector by the government.

Third: The Exchange Rate Channel CBOS applies a managed float exchange rate regime for more than a decade. CBOS daily monitors the actually applied exchange rates by all banks and exchange bureaus and calculates a weighted average. This average is then circulated to each commercial bank and authorized foreign exchange dealers in order for them to use as an indicative rate for determining the following-day’s rates. The banks are allowed a band around this average (currently ± 4%).

Required Reserve Ratio CBOS’s monetary policy mainstay tool is the required reserve ratio RRR. Each year, CBOS determines the appropriate level of liquidity in the economy that is consistent with given GDP growth and inflation rates. RRR is then used to sterilize the excess liquidity based on macro level indicators. The result is mixed. While RRR served well when setting the macro monetary indicators, it seems to be less effective in the day-to-day management of the liquidity hence there is need to supplement it with other tools. There is indication that RRR become ineffective in managing credit and lending where the banks’ excess reserves are large. Often RRR remains at the same level throughout the year. However, there are instances where CBOS opt to vary the RRR more frequently but the result did not give rise the continuation. Also, since RRR in Sudan is not numerated, the commercial banks consider it to be a costly tool.


Main Takeaways • Many consider that the Islamic financial system shows superior response

at times of financial crisis when compared to the conventional system. This is mainly because it is backed by some form of tangible assets although it does not eliminate the downside risks of the aftermath of a shock. Thus, a supplemental sterilization tool needs to be developed for countercyclical purpose.

• Various central banks find the required reserve ratio RRR to be instrumental as a macro management tool. Nonetheless it may not be convenient for day-to-day adjustment of liquidity level. Furthermore, where RRR is numerated, it costs the central bank, and, where it is not, it constitutes a tax on the commercial banks.

• It worth noting that RRR works better where interbank market exist and is developed. As such, it is advisable for Islamic central banks to pay special attention to developing and deepening interbank markets and familiarize with Mudaraba contracts.

• The challenge of ensuring adequate supply of Islamic monetary policy tools at the disposal of the central bank calls for a proactive approach towards developing an arsenal of Sharia-compliant instruments for countercyclical uses.

Finally, the rising geopolitical uncertainties, the recent economic and financial developments including in the US, China, and Europe pose serious challenges for monetary policy and requires CBOS to be vigilant and may be to start building up enough external reserves in order to weather out any unforeseen calamities.



The Republic of Iraq

Ms. Sahar Majed Hamed

Director General Assistant Central Bank of Iraq



Monetary Policy Developments in Iraq

Amid events at the local, regional and global level, overshadowed by unstable internal conditions and economic repercussions, the Central Bank of Iraq focused its efforts on the management of its monetary policy and unlimited support for the stimulation of economic growth in addition to its aim of enhancing stability on the level of the macro economy in general and the financial sector in particular.

Since early 2017, this year has witnessed a package of important measures and a wide range of ambitious measures, which the staff of the central bank of Iraq have striven to implement.

The most important results can be summarized as follows: 1. Continue the joint coordination and fruitful cooperation at the highest levels

between fiscal and monetary policy by establishing a joint committee which includes in its membership representatives of the Ministry of Finance and the Central Bank of Iraq with the task of holding consultations with the cabinet regarding policies and the development of general economic conditions.

2. Upgrading Iraq’s credit rating from the international rating agencies S&P and Fitch for a second time, to B– with a stable outlook. The stable outlook assumes that fiscal consolidation will continue over the next few years.

3. Develop the mechanism of state employee salary payments by converting the traditional system to an electronic one through salary payments to bank accounts with cashing facilities via electronic cards. The central bank of Iraq started with the cooperation of a number of public and private banks to process the salaries of central bank employees in this way. It is expected that, during the current year, this measure will be applied in most of the state ministries and agencies.

4. Thanks to the effective steps taken by the central bank in implementing the rules and principles of anti-money laundering and anti-terrorist financing, Iraq has made an exit from the gray zone within the international classification and evaluation of the Financial Action Task Force (FATF), thus avoiding the prospect of the country being cut off from the international financial system.

5. The central bank of Iraq places the utmost importance on the compliance issue by applying international standards to banks participating in the


Monetary Policy Developments in Iraq

Amid events at the local, regional and global level, overshadowed by unstable internal conditions and economic repercussions, the Central Bank of Iraq focused its efforts on the management of its monetary policy and unlimited support for the stimulation of economic growth in addition to its aim of enhancing stability on the level of the macro economy in general and the financial sector in particular.

Since early 2017, this year has witnessed a package of important measures and a wide range of ambitious measures, which the staff of the central bank of Iraq have striven to implement.

The most important results can be summarized as follows: 1. Continue the joint coordination and fruitful cooperation at the highest levels

between fiscal and monetary policy by establishing a joint committee which includes in its membership representatives of the Ministry of Finance and the Central Bank of Iraq with the task of holding consultations with the cabinet regarding policies and the development of general economic conditions.

2. Upgrading Iraq’s credit rating from the international rating agencies S&P and Fitch for a second time, to B– with a stable outlook. The stable outlook assumes that fiscal consolidation will continue over the next few years.

3. Develop the mechanism of state employee salary payments by converting the traditional system to an electronic one through salary payments to bank accounts with cashing facilities via electronic cards. The central bank of Iraq started with the cooperation of a number of public and private banks to process the salaries of central bank employees in this way. It is expected that, during the current year, this measure will be applied in most of the state ministries and agencies.

4. Thanks to the effective steps taken by the central bank in implementing the rules and principles of anti-money laundering and anti-terrorist financing, Iraq has made an exit from the gray zone within the international classification and evaluation of the Financial Action Task Force (FATF), thus avoiding the prospect of the country being cut off from the international financial system.

5. The central bank of Iraq places the utmost importance on the compliance issue by applying international standards to banks participating in the


window for buying and selling foreign currency. The central bank has determined a cautionary period for banks failing to achieve the compliance standard. If banks fail to comply, they are barred from accessing the window till they adjust their conditions.

6. The central bank adopted a new model for buying and selling foreign currency effective early August 2017 in order to facilitate currency sale procedures and activate verification and control mechanisms for daily selling operations to ensure their compliance with anti-money laundering and anti-terrorist financing rules. The most important provisions of these instructions were that the central bank of Iraq should enhance banks’ balances with their correspondent banks abroad in foreign currency to finance legally authorized banking operations. In addition to determining the dollar sell rate for that operation at 1190 Iraqi dinars per dollar provided that it should not exceed the selling margin of 10 dinars per dollar for all mediators or brokers.

7. Activate the international bank account number IBAN on the RTGS-ACH payment system. Banks were required to adopt the unified account numbers in internal transfers from the start of the year.

8. The CBI granted three Islamic banking business licences to three financial companies, allowing them to amend their activities from financial transfer companies to Islamic banking early in 2017. These banks were Islamic Al Quabuth for finance and investment, Islamic Al Rajeh for investment and finance, and Islamic Al Kurtass for investment and finance), with reference to CBI law No. 56 of 2004, the Islamic banks law No.43 of 2015, and the AML/FT law No.39 of 2015, stipulating that the banks should be subject to CBI surveillance and a capital increase to the prescribed limit amounting to ID 250 billion within a period not exceeding three years of the licensing date.

9. Support real activities related to lending for private sector projects through

specialized banks at an amount of ID 5 trillion for agriculture, industrial, real estate banks and the housing fund in order to reconstruct infrastructure and reduce unemployment, in addition to supporting small and medium-sized enterprises at an amount of ID 1 trillion.

10. Support financial stability and protect it against risks that may emerge from lower oil revenues through the purchase of treasury bills issued by the ministry of finance for the years 2015, 2016 and from the secondary market.


11. In order to strengthen the monetary market and support the Ministry of

Finance in managing the budget deficit; as the financial agent for the ministry, the central bank undertakes the issuance of national bonds in Iraqi dinars at an amount of ID 1 trillion with an annual interest rate of 8%.


11. In order to strengthen the monetary market and support the Ministry of

Finance in managing the budget deficit; as the financial agent for the ministry, the central bank undertakes the issuance of national bonds in Iraqi dinars at an amount of ID 1 trillion with an annual interest rate of 8%.



Sultanate of Oman

Mr. Mohammed Bin Rashid A. Jahwari

Economist, Economic Research & Statistical Department

Central Bank of Oman

Abu Dhabi, United Arab Emirates



Recent Economic and Financial Developments in Oman: Implications for the Banking Sector

Abstract Like other GCC countries, Oman has suffered from an economic slowdown and macroeconomic imbalances (large fiscal and current account deficits) due to the steep fall in oil prices. Inflation has also inched up mainly on account of the increase in energy prices and imported inflation. In line with the tightening of monetary conditions in the US and the domestic economic slowdown, banking activities (deposits and credit growth) have also slowed in the recent past. Notwithstanding this deceleration, the banking sector has displayed resilience with more than the required capital base and a low delinquency rate and it has posted a reasonable profit. Some upturn in economic activities has been witnessed in 2017 due to the recovery in oil prices and diversification efforts. The recovery in oil prices and several reform measures implemented by the government have also helped in containing the macroeconomic imbalances. Going forward, the economic recovery in Oman is expected to strengthen with the anticipated further increase in oil prices and various policy initiatives producing accelerated results. Implementation of VAT and approval for labour and FDI legislation would help greatly in improving the robust outlook for Oman over the medium term.


Recent Economic and Financial Developments in Oman: Implications for the Banking Sector

Abstract Like other GCC countries, Oman has suffered from an economic slowdown and macroeconomic imbalances (large fiscal and current account deficits) due to the steep fall in oil prices. Inflation has also inched up mainly on account of the increase in energy prices and imported inflation. In line with the tightening of monetary conditions in the US and the domestic economic slowdown, banking activities (deposits and credit growth) have also slowed in the recent past. Notwithstanding this deceleration, the banking sector has displayed resilience with more than the required capital base and a low delinquency rate and it has posted a reasonable profit. Some upturn in economic activities has been witnessed in 2017 due to the recovery in oil prices and diversification efforts. The recovery in oil prices and several reform measures implemented by the government have also helped in containing the macroeconomic imbalances. Going forward, the economic recovery in Oman is expected to strengthen with the anticipated further increase in oil prices and various policy initiatives producing accelerated results. Implementation of VAT and approval for labour and FDI legislation would help greatly in improving the robust outlook for Oman over the medium term.


I. Introduction

The GCC region, including Oman, has experienced an economic slowdown over the last few years due to the massive contraction in the hydrocarbon sector on the back of a sharp decline in oil prices. In fact, oil prices have undergone extreme movements over the last 10 years. They peaked in July 2008 but crashed by the year-end with the global financial crisis accentuated by the failure of Lehman Brothers. But oil prices then recovered, remaining elevated until the latter part of 2014 when they again started on a declining trajectory, touching a low in early 2016. There has since been some recovery, but they continued to remain much below the break-even price for the GCC’s government budgets. The GCC countries have also been trying to diversify to insulate their economies from the vagaries of oil prices, and some tangible success has been achieved in this regard, but there is a long way to go. Notwithstanding some headway in diversification, the hydrocarbon sector continues to be the mainstay of the economies in the GCC region, and the steep contraction in this sector has spilled over to the other sectors of the economy, including banking and finance. Against this backdrop, this paper attempts to outline the current macroeconomic and financial conditions along with their implications for the banking sector in Oman. The scheme of the paper is as follows. Section II analyzes the current macroeconomic conditions in the Oman. The implications of the monetary policy normalization in the US for Oman are discussed in Section III. Section IV contains the analysis on the spillovers of the current macroeconomic conditions on the banking sector in Oman while concluding observations are furnished in Section V.

II. Current Macroeconomic Conditions

Oman, like other GCC countries, has been witnessing an economic slowdown due to the sharp decline in oil prices and, accordingly, nominal GDP contracted for a second consecutive year in 2016 by 5.1 percent, after witnessing sustained robust growth over 2010–2014 (Chart 1). Nominal GDP from the hydrocarbon sector contracted by 23.7 percent during 2016 notwithstanding oil production increasing by 2.6 percent, while that of the non-hydrocarbon sector witnessed a marginal positive growth of 0.6 percent during the year, suggesting some delinking of the latter from the former. Notably, the authorities in Oman have been making concerted efforts to diversify the economy to reduce dependence on the hydrocarbon sector and the dedicated “Tanfeedh” program has been implemented, wherein three sectors, viz. manufacturing, tourism, and logistics have been targeted in the first phase with enhanced participation of the


private sector and foreign investors. Some progress has been achieved, as reflected in the positive nominal growth witnessed in the non-hydrocarbon sector during 2016 despite the steep contraction in the hydrocarbon sector. Oil prices have since recovered substantially from the low of early 2016, albeit continue to be much lower than the breakeven level for the state budget. The recovery in oil prices together with the policy drive for diversification has led to an upturn in the economy, and nominal GDP grew by 12.3 percent during the first half (1H) of 2017 as compared to the contraction of 11.1 percent in 1H of 2016 (Chart 1). The upturn in H1 of 2017 has been fairly broad-based with hydrocarbon and non-hydrocarbon sector growing at 34.9 percent and 3.8 percent, respectively. It is pertinent to note that, notwithstanding the low level of oil prices and some progress achieved in diversification, the hydrocarbon sector continues to be the main driver of the Omani economy, owing to interlinkages with non-oil activities. The empirical results of the model, estimated to establish this linkage, demonstrate that the growth in oil sector impacts the growth of the non-oil sector positively.17

17 A simple regression run on growth in non-petroleum activities with growth in petroleum activities as explanatory variable displays that the impact of the latter on the former is positive and statistically significant (Table below).

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Chart 1: Oil Prices and Nominal GDP

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private sector and foreign investors. Some progress has been achieved, as reflected in the positive nominal growth witnessed in the non-hydrocarbon sector during 2016 despite the steep contraction in the hydrocarbon sector. Oil prices have since recovered substantially from the low of early 2016, albeit continue to be much lower than the breakeven level for the state budget. The recovery in oil prices together with the policy drive for diversification has led to an upturn in the economy, and nominal GDP grew by 12.3 percent during the first half (1H) of 2017 as compared to the contraction of 11.1 percent in 1H of 2016 (Chart 1). The upturn in H1 of 2017 has been fairly broad-based with hydrocarbon and non-hydrocarbon sector growing at 34.9 percent and 3.8 percent, respectively. It is pertinent to note that, notwithstanding the low level of oil prices and some progress achieved in diversification, the hydrocarbon sector continues to be the main driver of the Omani economy, owing to interlinkages with non-oil activities. The empirical results of the model, estimated to establish this linkage, demonstrate that the growth in oil sector impacts the growth of the non-oil sector positively.17

17 A simple regression run on growth in non-petroleum activities with growth in petroleum activities as explanatory variable displays that the impact of the latter on the former is positive and statistically significant (Table below).

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Source: IMF Databse. P: Projection by IMF.

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Results of Regression (Sample period: 1981 to 2016)

Explanatory Variable Equation 1: GSER as dependent

variable Equation 1: GNPETRO as

dependent variable Coefficient Prob. Coefficient Prob.

C 8.477*** 0.000 8.788*** 0.000 GPETRO 0.092*** 0.008 0.089*** 0.004 AR (1) 0.465*** 0.006 0.469*** 0.002 Adjt. R 0.226 0.242 DW Stat. 2.042 2.048 GPETRO: Growth in petroleum sector; GSER: Growth in the services sector; and GNPETRO: Growth in non-petroleum sector. ***, **, and * denote 1 percent, 5 percent, and 10 percent significance level, respectively.

A cross-country analysis across the GCC region shows that all the countries, except Bahrain, underwent a nominal contraction during 2016, although the degree of contraction varied. As per the latest projections by the International Monetary Fund (IMF), all the GCC countries should grow in nominal terms during 2017. The nominal growth for Oman has been projected at the second highest among the GCC countries (a little lower than the nominal growth projected for the UAE) (Chart 1b). It may be noted that IMF in its October 2017 WEO has revised expected average oil prices downward to US$ 50.3 per barrel in 2017 and 2018 (from US$ 55.2 per barrel in April 2017 WEO). The price of Oman’s oil averaged US$ 51 a barrel during Jan–Aug 2017, significantly higher than the average of US$ 40.1 a barrel in 2016.

Inflation in Oman, as in many GCC countries, is largely conditioned by imported inflation and monetary conditions prevailing in the US due to the nature of the economy, i.e., a small open economy and the pegging of its currency to the US dollar. Nonetheless, domestic factors play an important role in determining inflation at times and therefore, the government as well as the Central Bank of Oman (CBO) keep a close watch on domestic developments that may affect inflation. Inflation in Oman edged up in recent periods from 0.3 percent in 2015 to 1.0 percent during 2016 and further to 1.7 percent during Jan–September 2017. The increase in inflation has been driven mainly by increase in energy prices and other government services fees as part of the macroeconomic reforms and pass-through of global commonalty prices. It could be seen that the imports-weighted Nominal Effective Exchange Rate (NEER) and inflation move in opposite


directions, suggesting the pass-through of imported inflation.18 The imports-weighted NEER depreciated in 2016 as well as during Jan–Aug 2017 and inflation went up during this period (Chart 2a). In the GCC region, inflation continues to be lowest for Oman in 2016, notwithstanding an uptick due to the factors mentioned earlier (Chart 2b).

Long-run coefficients (Sample period: 2002Q1 to 2017Q2)

Variable Coefficient Std. Error t-Statistic Prob.

RM2IND 0.117*** 0.009 12.633 0.000

NEER –1.019*** 0.239 –4.265 0.000

C 159.178*** 23.866 6.669 0.000

ECM –0.105 0.025 –4.229 0.000

***, **, and * denote 1 percent, 5 percent and 10 percent significance level, respectively.

Source: IMF Database.

18 An auto regressive distributed lags (ARDL) quarterly model estimated with inflation as dependent variable and real money supply growth and NEER as independent variables also suggest that pass through of imported inflation, captured through NEER, is statistically significant. ARDL model has been used as not all variables are found to be same unit root order.

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Chart 2: Inflation Environment


directions, suggesting the pass-through of imported inflation.18 The imports-weighted NEER depreciated in 2016 as well as during Jan–Aug 2017 and inflation went up during this period (Chart 2a). In the GCC region, inflation continues to be lowest for Oman in 2016, notwithstanding an uptick due to the factors mentioned earlier (Chart 2b).

Long-run coefficients (Sample period: 2002Q1 to 2017Q2)


RM2IND 0.117*** 0.009 12.633 0.000

NEER –1.019*** 0.239 –4.265 0.000

C 159.178*** 23.866 6.669 0.000

ECM –0.105 0.025 –4.229 0.000

***, **, and * denote 1 percent, 5 percent and 10 percent significance level, respectively.

Source: IMF Database.

18 An auto regressive distributed lags (ARDL) quarterly model estimated with inflation as dependent variable and real money supply growth and NEER as independent variables also suggest that pass through of imported inflation, captured through NEER, is statistically significant. ARDL model has been used as not all variables are found to be same unit root order.

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Chart 2: Inflation Environment


The oil sector continues to be the major source of government revenue in Oman. The significant drop in oil prices during 2016 resulted in a steep reduction in government revenue as well as in nominal merchandise exports, eventually resulting in an enlarged deficit in both the fiscal and current account (Chart 3). The fiscal deficit and current account deficit as percentage of GDP increased from 17.2 percent and 15.7 percent, respectively, in 2015 to 20.8 percent and 18.6 percent, respectively, during 2016. Although the drop in the revenue from oil exports remain the common main driver of the twin deficits in Oman, the fiscal deficit resulting from elevated government expenditure also seems to be contributing to the current account deficit.19 Therefore, any correction in the fiscal deficit, either through improved oil revenues or a reduction in government expenditure, would have a salutary effect on the current account deficit.

The enlarged fiscal deficit during 2015 and 2016 was financed through borrowings to a large extent and consequently, the government debt level increased substantially from RO 1.5 billion in 2014 to about RO 8.0 billion in 2016. The debt-to-GDP ratio also jumped significantly from 4.9 percent to 31.4 percent during this period; however, it has remained within prudent limits.

19 This means that the Ricardian equivalence principle does not appears to be holding true in the case of Oman, which suggests that any increase in government expenditure will be counterbalanced by a reduction in private consumption and vice versa. This situation might be explained by the dominant role of the state in the economy and the nature of a private sector which relies heavily on government spending and privileges with relatively low taxation rates.

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Chart 3: Twin Deficits: Fiscal and Current Account


Notwithstanding a substantial jump in borrowing, the Government was able to successfully borrow from the market at market-linked interest rates.

The authorities in Oman are exerting efforts to deal with the twin deficits problem, and many reform measures have already been implemented, which, inter alia, included a reduction in energy subsidies, increasing other government services fees, an increase in the corporate tax rate, rationalization of government expenditure, etc. Going forward, the expected implementation of the value-added tax (VAT) from 2018 should support fiscal policy, boosting the non-oil revenue of the government and insulating the fiscal balance from extreme swings in oil prices. In fact, VAT should provide a solid base for fiscal policy and pave the way for further tax reforms, including the implementation of an income tax at a later stage. The pickup in economic activities, especially non-hydrocarbon, on the back of the diversification push through the “Tanfeedh” plan and enhanced participation of the foreign investors through Special Economic Zones (SEZs) and expected approval for FDI legislation should also enhance tax revenue and improve the fiscal balance, enabling the government to pursue a more sustainable fiscal policy.

III. Implication of US Monetary Policy Normalization

Monetary policy in Oman has relinquished independence by opting for a currency peg with the US dollar, and all other macro objectives are attained by sticking to this nominal anchor. Consequently, monetary conditions prevailing in the US are automatically transmitted to Oman to a large extent. An empirical exercise that finds the long-run relationship between demand for money and the US interest rate positive and statistically significant also corroborates such a transmission mechanism.20 Nonetheless, the Central Bank of Oman (CBO) is able to gain some space for independent monetary policy, thanks to some prudential limits, such as a limit on banks’ exposure in foreign exchange, a lending-to-deposit ratio, etc.

20 An ARDL model has been used to estimate the money demand function of Oman with money supply (M2) as dependent variable and nominal GDP(NGDP) and effective federal fund rate (EFFR) as explanatory variables. Nominal GDP is a scale variable, while EFFR represents the foreign opportunity cost of holding money. Quarterly data from 2001:Q1 to 2017 Q2 are used. The results are furnished below.


Notwithstanding a substantial jump in borrowing, the Government was able to successfully borrow from the market at market-linked interest rates.

The authorities in Oman are exerting efforts to deal with the twin deficits problem, and many reform measures have already been implemented, which, inter alia, included a reduction in energy subsidies, increasing other government services fees, an increase in the corporate tax rate, rationalization of government expenditure, etc. Going forward, the expected implementation of the value-added tax (VAT) from 2018 should support fiscal policy, boosting the non-oil revenue of the government and insulating the fiscal balance from extreme swings in oil prices. In fact, VAT should provide a solid base for fiscal policy and pave the way for further tax reforms, including the implementation of an income tax at a later stage. The pickup in economic activities, especially non-hydrocarbon, on the back of the diversification push through the “Tanfeedh” plan and enhanced participation of the foreign investors through Special Economic Zones (SEZs) and expected approval for FDI legislation should also enhance tax revenue and improve the fiscal balance, enabling the government to pursue a more sustainable fiscal policy.

III. Implication of US Monetary Policy Normalization

Monetary policy in Oman has relinquished independence by opting for a currency peg with the US dollar, and all other macro objectives are attained by sticking to this nominal anchor. Consequently, monetary conditions prevailing in the US are automatically transmitted to Oman to a large extent. An empirical exercise that finds the long-run relationship between demand for money and the US interest rate positive and statistically significant also corroborates such a transmission mechanism.20 Nonetheless, the Central Bank of Oman (CBO) is able to gain some space for independent monetary policy, thanks to some prudential limits, such as a limit on banks’ exposure in foreign exchange, a lending-to-deposit ratio, etc.

20 An ARDL model has been used to estimate the money demand function of Oman with money supply (M2) as dependent variable and nominal GDP(NGDP) and effective federal fund rate (EFFR) as explanatory variables. Nominal GDP is a scale variable, while EFFR represents the foreign opportunity cost of holding money. Quarterly data from 2001:Q1 to 2017 Q2 are used. The results are furnished below.


Long-Run Coefficients


LNGDP 0.931461 0.076571 12.164609 0.0000

EFFR –0.113737 0.019981 –5.692378 0.0000

C 1.571479 0.697247 2.253833 0.0286

ECM –0.125193 0.022324 -5.607980 0.0000

–0.125193 0.022324 -5.607980 0.0000

–0.125193 0.022324 -5.607980 0.0000

–0.125193 0.022324 -5.607980 0.0000

***, **, and * denote 1 percent, 5 percent and 10 percent significance level, respectively. LNGDP: long-term GDP. EFFR: Effective Federal Funds Rate

Oman’s policy rate (repo rate) follows the federal fund rate (FFR) through one-month US$ LIBOR. The policy rate is defined as one-month US$ LIBOR plus a spread of 50 basis points (bps) or 1 percent, whichever is higher, and one-month US$ LIBOR follows the FFR very closely (Chart 3a). The broad principles of the normalization of monetary policy in the US from its ultra-accommodative stance were finalized and released by the Federal Reserve after its September 2014 Federal Open Market Committee (FOMC) meeting, followed by the announcement of more details regarding an increase in the federal funds rate and other short-term interest rates at its March 2015 FOMC meeting. Eventually, the normalization process was set in motion at the December 2015 FOMC meeting by raising the target range for the FFR for the first time since December 2008. Since December 2015, the Fed has continued to gradually raise the target range for the FFR in line with the strengthening of economic conditions and the evolving macroeconomic outlook. With five hikes each of 25 basis points (bps) since December 2015, the current target range of FFR stands at 1.00–1.25 percent.


Monetary conditions in Oman have also been affected by the normalization of monetary policy in the US and, accordingly, interest rates have increased across the spectrum following those of the US (Charts 3b and 3c). The weighted average overnight interbank rate, which follows the FFR very closely, increased from 0.12 percent in November 2015 to 0.24 percent during December 2015 and further to 0.54 percent in December 2016 and 1.16 percent in August 2017. The weighted average deposits rate in Oman hardened from 0.94 percent in December 2015 to 1.67 percent during August 2016, while the weighted average lending rate hardened from 4.76 percent to 5.16 percent during this period. At the same time, money supply growth in Oman has also decelerated significantly, suggesting some tightening of monetary conditions, while that of the US also decelerated during recent periods but at a much slower pace (Chart 3d). The year-on-year (YoY) growth in broad money declined sharply from 10.0 percent at the end of December 2015 to 1.08 percent as at end-December 2016

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Linear (M2 (YoY)-Oman) Linear (M2(YoY)-USA (RHS))

Chart 4: Monetary Conditions


Monetary conditions in Oman have also been affected by the normalization of monetary policy in the US and, accordingly, interest rates have increased across the spectrum following those of the US (Charts 3b and 3c). The weighted average overnight interbank rate, which follows the FFR very closely, increased from 0.12 percent in November 2015 to 0.24 percent during December 2015 and further to 0.54 percent in December 2016 and 1.16 percent in August 2017. The weighted average deposits rate in Oman hardened from 0.94 percent in December 2015 to 1.67 percent during August 2016, while the weighted average lending rate hardened from 4.76 percent to 5.16 percent during this period. At the same time, money supply growth in Oman has also decelerated significantly, suggesting some tightening of monetary conditions, while that of the US also decelerated during recent periods but at a much slower pace (Chart 3d). The year-on-year (YoY) growth in broad money declined sharply from 10.0 percent at the end of December 2015 to 1.08 percent as at end-December 2016

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M2 (YoY)-Oman M2(YoY)-USA (RHS)

Linear (M2 (YoY)-Oman) Linear (M2(YoY)-USA (RHS))

Chart 4: Monetary Conditions


but improved to 3.7 percent at the end of August 2017. Apart from following the monetary conditions of the US, the deceleration in the growth of the money supply in Oman is also exacerbated by the overall economic slowdown experienced during the last few years.

IV. Banking Sector Conditions in Oman

Oman’s financial sector is dominated by the banking sector, as other segments of the financial intermediation are still at the incipient stage. Accordingly, the banks remain the main conduit for the financial intermediation between savers and investors. Financial intermediation through banks, measured in terms of the credit-to-GDP ratio, improved from 47.4 percent in 2010 to 86.8 percent during 2016. Similarly, the deposits-to-GDP ratio increased from 46.5 percent to 80.1 percent during this period. Therefore, the banking sector is critical not only for providing the necessary funding to various segments and boosting economic activities but also for macroeconomic stability. The CBO monitors banking conditions very closely and takes the necessary policy measures to mitigate any potential risk that could adversely affect the health of banking sector. Towards this end, the CBO has been at the forefront of implementing various international regulatory and supervisory principles in the banking sector of Oman. For example, the CBO has implemented the Basel Committee’s Liquidity Coverage Ratio (LCR) to deal with liquidity risk in the banks of Oman. Another such measure, the Net Stable Funding Ratio, which helps in reducing funding risk and promoting sustainable asset-liability management, will become effective for banks in Oman from January 2018 with a minimum ratio of 100 percent.

As referred earlier, US monetary conditions are transmitted to Oman, but the performance of the banking sector is largely dependent on current macroeconomic conditions in Oman. The slowdown in economic activities, on the back of low oil prices, has impinged on growth in Oman’s banking sector (Chart 5). The growth in bank credit slowed from 11.2 percent in 2015 to 10.1 percent during 2016 and further to 5.7 percent during Jan–Sept 2017. Likewise, the growth in bank deposits declined from 8.0 percent in 2015 to 5.2 percent in 2016 and further to 5.8 percent during Jan–Sept 2017.


*Data on growth in non-oil GDP for 2017 pertains up to June.

Notwithstanding the slowdown in banking activities, almost all the prudent indicators suggest that the banking sector has remained resilient, reflecting pro-active policy measures undertaken by the CBO and the prudent practices of the banks. Banks have remained well capitalized as reflected in a capital adequacy ratio of 16.8 percent, much higher than required by the CBO at 13.25 percent. The commercial banks were also able to post a reasonable profit in 2016 (RO 379 million), although lower than in 2015. Among various kinds of risks, credit risk remains predominant in the banking sector with credit risk-weighted assets (CRWA) constituting over 90 percent of total risk-weighted assets, followed by the share of operational risk-weighted assets and market risk-weighted assets (MRWA) at about 7 percent and 2 percent, respectively (Financial Stability Report, CBO, 2017). The quality of banks’ assets, which captures the credit risk, has not been affected much by the economic slowdown, as reflected in delinquency rate21 going up marginally from 1.9 percent in 2015 to 2.1 percent during 2016. The credit gap, which measures overleverage, also captures the credit risk. The private sector credit-to-GDP gap increased during 2016, but this is mainly attributed to a sharp contraction in nominal GDP (denominator) instead of excessive credit growth and hence does not reflect any build-up of risk (FSR, CBO, 2017).

21 The gross non-performing loans as a proportion to total loans and advances.

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Chart 5: Credit and Deposit Growth


*Data on growth in non-oil GDP for 2017 pertains up to June.

Notwithstanding the slowdown in banking activities, almost all the prudent indicators suggest that the banking sector has remained resilient, reflecting pro-active policy measures undertaken by the CBO and the prudent practices of the banks. Banks have remained well capitalized as reflected in a capital adequacy ratio of 16.8 percent, much higher than required by the CBO at 13.25 percent. The commercial banks were also able to post a reasonable profit in 2016 (RO 379 million), although lower than in 2015. Among various kinds of risks, credit risk remains predominant in the banking sector with credit risk-weighted assets (CRWA) constituting over 90 percent of total risk-weighted assets, followed by the share of operational risk-weighted assets and market risk-weighted assets (MRWA) at about 7 percent and 2 percent, respectively (Financial Stability Report, CBO, 2017). The quality of banks’ assets, which captures the credit risk, has not been affected much by the economic slowdown, as reflected in delinquency rate21 going up marginally from 1.9 percent in 2015 to 2.1 percent during 2016. The credit gap, which measures overleverage, also captures the credit risk. The private sector credit-to-GDP gap increased during 2016, but this is mainly attributed to a sharp contraction in nominal GDP (denominator) instead of excessive credit growth and hence does not reflect any build-up of risk (FSR, CBO, 2017).

21 The gross non-performing loans as a proportion to total loans and advances.

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Chart 5: Credit and Deposit Growth


V. Concluding Observations

Oman has witnessed an economic slowdown, like other GCC countries, due to the steep fall in oil prices. This also resulted in twin deficits in the fiscal and current accounts. The Government has, however, undertaken several reform measures to reinstate the macroeconomic balance and promote diversification to reduce excessive dependence on the hydrocarbon sector. The recovery in oil prices from the low of early 2016, coupled with positive results produced by reform measures, has led to an upturn in the economy, and nominal GDP grew by 12.3 percent during 1H of 2017 as against a negative 11.1 percent in 1H of 2016.

Although monetary conditions have tightened somewhat, mainly reflecting conditions in the US, credit has continued to grow in line with domestic economic activities, especially to non-oil activities. The banks in Oman have also displayed resilience, despite the economic slowdown and deceleration in business activities, and they have maintained a good capital base and contained the delinquency rate. At the same time, banks were able to post a reasonable profit in 2016 (although lower than the previous year).

Going forward, the economic recovery is expected to strengthen, with an anticipated further increase in oil prices (as a result of continuous supply management efforts by OPEC and non-OPEC countries and robust global demand) and various policy initiatives, such as diversification under the “Tanfeedh” program, which is expected to have accelerated results. Implementation of VAT and approval for labor and FDI legislation would help greatly in improving the robust macroeconomic outlook of Oman over the medium term.



The State of Palestine

Mr. Mohamed Atallah

Director of Research & Monetary Policy

Palestine Monetary Authority




The State of Palestine

Mr. Mohamed Atallah

Director of Research & Monetary Policy

Palestine Monetary Authority



Background

The Palestinian economy is a small, open and free-market economy.22 It also operates within an environment that involves monetary forces in the form of the policy decisions taken in the US and in Jordan as well as in Israel, and the exchange rate of the Israeli currency. A range of non-monetary factors is also relevant, including the varying restrictions placed over the years on Palestinian trade (both internal and external closures) and on the employment of Palestinian labor in Israel and the settlements, the growth and level of demand in the Israeli economy (as the Palestinian economy’s dominant trade partner), and fluctuating external aid flows.

In addition, the Palestinian economy operates in the absence of a national currency,23 which precludes the formulation of a comprehensive monetary policy. Thus, the Palestine Monetary Authority (PMA), has no control over the domestic money supply and little influence on domestic interest rates, exchange rates, inflation, and asset prices. This high-risk environment affects the main economic indicators such as growth and inflation, as well as interest and currency exchange rates, asset prices, and even financial and monetary stability.

This background paper is intended to shed light on the implications of some key aspects of monetary and financial policy and stability.

Recent economic and financial developments and its implications for banks

The global economy witnessed many economic developments in 2016, notably a slowdown in growth, and a decline in the prices of oil and primary commodities. Risks to global financial stability also increased, especially at the beginning of 2016. At the local level, the performance of the Palestinian economy improved relatively in 2016, amid increasing potential risks to financial stability given the direct and indirect links between the government and the banking sector on one hand, and between the Palestinian economy and neighboring countries, especially Israel, on the other hand.

(22) It is open for 4.8 million Palestinians living in West Bank and Gaza Strip, in an area of 6,220 km2, of which 5,860 km2 is in the West Bank, and 360 km2 in the Gaza Strip.

(23) Instead, there are four main foreign currencies circulated in the Palestinian market: the US dollar-USD, the Jordanian dinar JD, the New Israeli shekel ILS, and to a lesser extent the euro.


Background

The Palestinian economy is a small, open and free-market economy.22 It also operates within an environment that involves monetary forces in the form of the policy decisions taken in the US and in Jordan as well as in Israel, and the exchange rate of the Israeli currency. A range of non-monetary factors is also relevant, including the varying restrictions placed over the years on Palestinian trade (both internal and external closures) and on the employment of Palestinian labor in Israel and the settlements, the growth and level of demand in the Israeli economy (as the Palestinian economy’s dominant trade partner), and fluctuating external aid flows.

In addition, the Palestinian economy operates in the absence of a national currency,23 which precludes the formulation of a comprehensive monetary policy. Thus, the Palestine Monetary Authority (PMA), has no control over the domestic money supply and little influence on domestic interest rates, exchange rates, inflation, and asset prices. This high-risk environment affects the main economic indicators such as growth and inflation, as well as interest and currency exchange rates, asset prices, and even financial and monetary stability.

This background paper is intended to shed light on the implications of some key aspects of monetary and financial policy and stability.

Recent economic and financial developments and its implications for banks

The global economy witnessed many economic developments in 2016, notably a slowdown in growth, and a decline in the prices of oil and primary commodities. Risks to global financial stability also increased, especially at the beginning of 2016. At the local level, the performance of the Palestinian economy improved relatively in 2016, amid increasing potential risks to financial stability given the direct and indirect links between the government and the banking sector on one hand, and between the Palestinian economy and neighboring countries, especially Israel, on the other hand.

(22) It is open for 4.8 million Palestinians living in West Bank and Gaza Strip, in an area of 6,220 km2, of which 5,860 km2 is in the West Bank, and 360 km2 in the Gaza Strip.

(23) Instead, there are four main foreign currencies circulated in the Palestinian market: the US dollar-USD, the Jordanian dinar JD, the New Israeli shekel ILS, and to a lesser extent the euro.


These developments pose a number of internal and external challenges to the Palestinian banking sector.24 The impact on the safety and soundness of the banking sector requires close monitoring and follow-up by the PMA. The most significant challenges affecting the banking sector include:

Rising geographical uncertainties, lower oil prices, and rising public debt

Regional political and economic challenges are a main source of risks. If not addressed properly, the repercussions will affect not only the banking sector but also the overall Palestinian economy.

The consequences of lower oil and other commodity prices have directly impacted public revenues. Public revenues increased significantly in 2016 (17.2 percent) compared to last year despite a decline in foreign grants. Adding to that has been an improved ability to collect clearing revenues.25

This development has led on one hand to significant improvements in both the current and overall deficits (before and after foreign aid). The current deficit dropped significantly (almost by 80.1 percent compared to last year) to around USD 110 million, whereas the overall account achieved a surplus of almost USD 440 million.

On the other hand, public debt dropped by the end of 2016 by almost 2.1 percent compared to last year, to USD 2,483.8 million. This drop is mainly due to a decrease in local public debt (from banks) by almost 1.8 percent, in addition to a drop in external debt by 2.5 percent compared to last year.

In view of the significant impact of public financing developments on the banking sector and financial stability in Palestine, and in light of the direct and indirect interlinkages between the government and the banking sector, the PMA continues to closely monitor these developments to ensure financial stability and reduce the exposure of the banking sector to government-related risks.

Challenges from policy normalization in advanced economies

Changes and developments in the global economy have various effects on the Palestinian economy. Although sudden changes in global growth, trade, or even

The Palestinian banking sector consists of 15 licensed banks (foreign and local) operating in Palestine, of which eight banks were foreign (seven Jordanian, and one Egyptian). Also three out of the 15 banks were operating according to Islamic rules.

(25) According to the Paris Economic Agreement, revenues are collected by Israel on behalf of the Palestinian government, and at a later stage transferred to the Palestinian authorities, after deducting 3 percent as collection fees.


global political and economic linkages have a limited impact on the Palestinian economy, fluctuations in commodity markets have a major influence on Palestinian market prices. In addition, the exchange and interest rates of major currencies play a major role in defining the cost of borrowing in these currencies in the domestic market. However, the Palestinian economy is mainly affected by its close links to the region, especially to Israel, given its trade activities and the reliance of its banking sector on a multi-currency system in view of the absence of a Palestinian national currency.

Disparities were recorded in global monetary policy trends. As interest rates continued to rise in the United States, indicating a gradual end to an era of expansionary policies, other central banks in advanced economies opted for additional monetary expansion. In fact, Japan and the euro zone recorded negative interest rates, hoping to boost growth and inflation to their target levels. Decision-makers in other economies such as China relied on fiscal stimulus packages instead of monetary easing to support their growth and bridge existing gaps.

In this regard, the interrelated nature of financial transactions with these countries poses some challenges to the Palestinian economy in general and its banking sector in particular. In general, there are four main sources of potential challenges to the banking sector that may be addressed here: lending to non-residents, changes in interest rates, exchange rates and placements abroad.

1. Lending to non-residents

Credit granted by banks operating in Palestine is heavily directed towards resident sectors in the local economy, with some marginal loans granted to non-residents. This has been the prevailing trend for a long period of time. In 2016, credit granted to non-residents reached USD 65.4 million, only 1.2 percent of total credit, compared to 0.4 percent in 2015.

In fact, the risks associated with non-resident credits remain limited and insignificant, and do not represent a major concern for banking sector and financial stability in Palestine, especially given the supervisory measures, which govern and control granting mechanisms, particularly Instructions No. (5/2008).26

(26) According to this instruction, such credits are to be granted exclusively in Palestine, as part of a plan that encourages investments, in line with adequate and sufficient guarantees “in the case of cash guarantees”, or their registration in the name of the bank “in the case of in-kind guarantees.” Otherwise, granting credit requires the PMA’s prior written consent.


global political and economic linkages have a limited impact on the Palestinian economy, fluctuations in commodity markets have a major influence on Palestinian market prices. In addition, the exchange and interest rates of major currencies play a major role in defining the cost of borrowing in these currencies in the domestic market. However, the Palestinian economy is mainly affected by its close links to the region, especially to Israel, given its trade activities and the reliance of its banking sector on a multi-currency system in view of the absence of a Palestinian national currency.

Disparities were recorded in global monetary policy trends. As interest rates continued to rise in the United States, indicating a gradual end to an era of expansionary policies, other central banks in advanced economies opted for additional monetary expansion. In fact, Japan and the euro zone recorded negative interest rates, hoping to boost growth and inflation to their target levels. Decision-makers in other economies such as China relied on fiscal stimulus packages instead of monetary easing to support their growth and bridge existing gaps.

In this regard, the interrelated nature of financial transactions with these countries poses some challenges to the Palestinian economy in general and its banking sector in particular. In general, there are four main sources of potential challenges to the banking sector that may be addressed here: lending to non-residents, changes in interest rates, exchange rates and placements abroad.

1. Lending to non-residents

Credit granted by banks operating in Palestine is heavily directed towards resident sectors in the local economy, with some marginal loans granted to non-residents. This has been the prevailing trend for a long period of time. In 2016, credit granted to non-residents reached USD 65.4 million, only 1.2 percent of total credit, compared to 0.4 percent in 2015.

In fact, the risks associated with non-resident credits remain limited and insignificant, and do not represent a major concern for banking sector and financial stability in Palestine, especially given the supervisory measures, which govern and control granting mechanisms, particularly Instructions No. (5/2008).26

(26) According to this instruction, such credits are to be granted exclusively in Palestine, as part of a plan that encourages investments, in line with adequate and sufficient guarantees “in the case of cash guarantees”, or their registration in the name of the bank “in the case of in-kind guarantees.” Otherwise, granting credit requires the PMA’s prior written consent.


2. Interest rates

In the absence of a national currency, the PMA has resorted to a policy of non-intervention with respect to interest rates and allowing rates to move within the market as dictated by banks’ internal policy and inter-bank competition. However, this exposes the Palestinian banking sector to the changing interest rates of these currencies. In fact, changes of these rates in the Palestinian market depend on the rates in the issuing countries.

An analysis of credit and debit interest rates over the course of 2016 shows that the interest rate spread (margin) has picked up compared to 2015 for all currencies circulated in the Palestinian market. This margin dropped from 4.98 percent in 2015 to 4.85 percent in 2016 for the US dollar, from 4.75 percent to 4.06 percent for the Jordanian dinar, and from 6.23 percent to 5.45 percent for the New Israeli shekel.

The effects of changing interest rates are not limited to the banking sector but affect all parties who use these currencies in the Palestinian market.

3. Exchange rates

Exchange rates are among the main challenges facing the Palestinian economy in general, and the banking sector in particular due to the usage and circulation of more than one currency in the Palestinian market, and the risks this poses to investors and traders, especially the exchange rates of the US dollar against the New Israeli shekel (ILS). It is worth noting that the exchange rate of the US

Chart 1: Lending and deposit rates in Palestine, 2015–2016

Source: PMA database.


dollar against the New Israeli shekel (and consequently the exchange rate of the dinar against the shekel) has experienced sharp fluctuations in the past years, amid a state of instability. The situation did not change in 2016, and the US dollar has again weakened against the growing strength of the Israeli shekel, recording an average drop of 1.2 percent during the year compared to 2015.


Changes in the exchange rates of the US dollar against the New Israeli shekel (ILS) can affect the Palestinian economy and banking sector in more than one way. These changes have an impact on the government’s budget, since it receives foreign aid in currencies such as the dollar and the euro, whereas the major part of its expenditure is in shekels (mainly wages and salaries). Inevitably, changes in exchange rates will impact on the budget deficit. They also affect public debt, especially borrowing from the banking sector, given that most of this borrowing is in shekels.

Similarly, exchange rate fluctuations have an impact on the assets of the banking sector, as they make the management of exchange and settlement risks in all currencies more difficult. These risks grow as fluctuations in exchange rates increase. Therefore, banks are constantly attempting to align their assets and liabilities with the different currencies, and take prudential measures against exchange rate risks, especially as the US dollar accounted for about 39.7 percent of total bank assets by end of 2016, whereas assets in dinars accounted for about 25.8 percent, and assets in shekels reached 30.1 percent. The remaining

Chart 2: Annual change in USD exchange rate against NIS, 2012–2016


dollar against the New Israeli shekel (and consequently the exchange rate of the dinar against the shekel) has experienced sharp fluctuations in the past years, amid a state of instability. The situation did not change in 2016, and the US dollar has again weakened against the growing strength of the Israeli shekel, recording an average drop of 1.2 percent during the year compared to 2015.


Changes in the exchange rates of the US dollar against the New Israeli shekel (ILS) can affect the Palestinian economy and banking sector in more than one way. These changes have an impact on the government’s budget, since it receives foreign aid in currencies such as the dollar and the euro, whereas the major part of its expenditure is in shekels (mainly wages and salaries). Inevitably, changes in exchange rates will impact on the budget deficit. They also affect public debt, especially borrowing from the banking sector, given that most of this borrowing is in shekels.

Similarly, exchange rate fluctuations have an impact on the assets of the banking sector, as they make the management of exchange and settlement risks in all currencies more difficult. These risks grow as fluctuations in exchange rates increase. Therefore, banks are constantly attempting to align their assets and liabilities with the different currencies, and take prudential measures against exchange rate risks, especially as the US dollar accounted for about 39.7 percent of total bank assets by end of 2016, whereas assets in dinars accounted for about 25.8 percent, and assets in shekels reached 30.1 percent. The remaining

Chart 2: Annual change in USD exchange rate against NIS, 2012–2016


currencies (mostly the euro) accounted for about 4.4 percent of total bank assets.27

Fluctuating exchange rates also had an impact on the relative importance of credits and deposits. As such, the relative importance of credits granted in dollar dropped to 49.1 percent of total credits granted in 2016, compared to 50.3 percent in 2015. Moreover, the relative importance of credits granted in dinars also dropped to 14.2 percent compared to 14.8 percent over the same period. This decrease had a positive impact on the shekel, whose relative importance increased to 35.8 percent of total credits granted in 2016 compared to 34.1 percent in 2015. However, the effects of this drop on other currencies (mostly the euro) were marginal, at 0.9 percent compared to 0.8 percent during the same period.28

On another side, the relative importance of deposits in dollar rose from 37.1 percent in 2015 to 37.3 percent in 2016. It also increased for other currencies (mostly the euro) from 3.7 percent to 4.7 percent. This increase had a negative impact on deposits in shekels and dinars. In fact, the relative importance of deposits in shekels dropped from 33.5 percent to 33.1 percent, whereas it dropped from 25.7 percent to 24.9 percent for deposits in dinars.29

4. Placements abroad

Placements abroad30 are one way to use funds available at banks. By the end of 2016, these placements increased by 8.5 percent compared to the previous year.

Despite this rise, their share dropped to 30.6 percent of total bank and non-bank deposits (customers’ deposits + bank deposits + PMA deposits) compared to 31.5 percent in 2015 (keeping in mind that the maximum limit set by the PMA is 55 percent of total deposits). The relative importance of these placements dropped to 25.3 percent of total bank assets compared to 26.3 the previous year.

Due to these placements, the Palestinian banking sector has been subject to marginal exposure to international financial markets. It should be noted that, on average, around 74 percent of these placements are invested as deposits with a

(27) Annual Report 2016, PMA, July 2017. (28) Financial Stability Report 2016, PMA, August 2017. (29) Ibid. (30) According to PMA Instruction No. 5/2008, article 5/7, placements abroad are defined as “cash

balances deposited with banking financial institutions outside Palestine, in addition to investments, whether in financial markets or as facilities granted to be deployed abroad and include certificates of deposit, bonds issued by foreign governments or institutions, investment in stocks of foreign companies, foreign investment funds and syndicated loans and any other facilities extended for the purpose of investment outside Palestine”.


number of foreign banks, and 25 percent are invested in other investment tools, while no more than 1 percent is extended as credits to non-residents.

In general, data indicate that the percentage of the Palestinian banking sector’s assets placed abroad has tended to decline over the past few years, which decreased the exposure of the banking sector to external risks while increasing its exposure to internal ones, especially as the drop in placements abroad was coupled with a rise in local investment of assets. The PMA adopted this policy to strengthen the link between the banking sector and the local economy. Accordingly, the ratio of loans to deposits started to increase and reached 64.8 percent whereas the ratio of placements abroad to total deposits dropped to 25.3 percent by the end of 2016.


Generally, placements abroad are subject to stringent supervision by the PMA, which monitors the concentration of placements at state, financial institution and currency levels. Additionally, the PMA’s supervision is intended to safeguard against bank investment in financial derivatives except for hedging purposes and in almost negligible amounts.

Bank borrowing conditions, assets quality, and non-performing loans

The macroeconomic environment in which the Palestinian economy operates involves many risks and challenges. Therefore, the policy of prudent monitoring of the banking sector adopted by the PMA acts as a safety valve that ensures the stability of the banking sector, which, in turn, is a key driver of economic growth. Due to this monitoring, the banking sector has succeeded in addressing many risks and neutralizing or mitigating their potential impact on its activities.

The peculiarity of the Palestinian situation is reflected in the limited set of policy instruments. Thus, maintaining the credit channel is the main transmission

Chart 3: Placements abroad vs credits, 2012–2016

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number of foreign banks, and 25 percent are invested in other investment tools, while no more than 1 percent is extended as credits to non-residents.

In general, data indicate that the percentage of the Palestinian banking sector’s assets placed abroad has tended to decline over the past few years, which decreased the exposure of the banking sector to external risks while increasing its exposure to internal ones, especially as the drop in placements abroad was coupled with a rise in local investment of assets. The PMA adopted this policy to strengthen the link between the banking sector and the local economy. Accordingly, the ratio of loans to deposits started to increase and reached 64.8 percent whereas the ratio of placements abroad to total deposits dropped to 25.3 percent by the end of 2016.


Generally, placements abroad are subject to stringent supervision by the PMA, which monitors the concentration of placements at state, financial institution and currency levels. Additionally, the PMA’s supervision is intended to safeguard against bank investment in financial derivatives except for hedging purposes and in almost negligible amounts.

Bank borrowing conditions, assets quality, and non-performing loans

The macroeconomic environment in which the Palestinian economy operates involves many risks and challenges. Therefore, the policy of prudent monitoring of the banking sector adopted by the PMA acts as a safety valve that ensures the stability of the banking sector, which, in turn, is a key driver of economic growth. Due to this monitoring, the banking sector has succeeded in addressing many risks and neutralizing or mitigating their potential impact on its activities.

The peculiarity of the Palestinian situation is reflected in the limited set of policy instruments. Thus, maintaining the credit channel is the main transmission

Chart 3: Placements abroad vs credits, 2012–2016

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25

35

45

55

65

75

2012 2013 2014 2015 2016

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Placements abraod loans


channel for monetary policy. However, this channel remains subject to exposures to external as well as internal factors. The most prominent internal factors are the continued exposure to the government, given the ongoing drop in foreign aid from donor countries, and the exposure to the private sector and the rapid growth of its credit.

1. Exposures to Public Sector (Government)

Credit granted to the government is one of the main factors that expose the banking sector to the public sector since it is the main source of funding for a part of the government’s budget. This is caused by prevailing uncertainties concerning public finances, limited local resources, a continuous drop in foreign aid, as well as the fact that the regular flow of clearing revenues and foreign aid is largely affected by external factors that are not subject to the government’s control. In this regard, credit granted to the government has accelerated over the past few years, posing one of the most significant inherent risks that could affect financial stability, especially if public finances undergo additional pressures.

Despite the relative decline of crowding out (competition) with the private sector in 2016, structural imperfections in the budget and growing medium and long-term pressures on the government may increase government competition for credit against other sectors. Such a competition not only affects financial stability, but also negatively impacts the economy, especially as this competition could increase interest rates and hinder investment (one of the main components of domestic demand), thus affecting growth rates.


Figure 4: Government loans as a percent of banks’ equity, 2012–2016


Although the concept of a single borrower limit does not apply to the government, the PMA has succeeded in closely monitoring and preventing this concentration through a friendly understanding with the banking sector according to which credit granted to the government would not exceed 100 percent of ownership equity. By the end of 2016, government credit to bank ownership equity dropped to 84.2 percent compared to 99.2 percent in 2015.

At the same time, credit granted to public sector employees is the second main factor that exposes the banking sector to the public sector, given that developments in these credits are directly related to developments in the budget. By the end of 2016, credit granted to these employees witnessed a 26.6 percent increase compared to 2015. Therefore, this type of credit accounted for 18.9 percent of total credit granted and 77.2 percent of ownership equity in 2016, compared to 17.6 percent and 70.1 percent in 2015.

Credit granted to private sector companies under government contract is the third channel of inherent risk, especially given that the regular payments by the government to private sector suppliers depends mainly on available liquidity. Moreover, the government’s inability to pay could undermine the financial position of private sector suppliers and force them to borrow from banks to settle their business payments. Thus, the ability of banks to collect their debt depends on the payment by the government of outstanding payments to suppliers, which in turn depends on the government having sufficient funds to pay. In 2016, the arrears of private sector companies under government contract increased by 10.3 percent compared to 2015. Moreover, these arrears amounted to 78.0 of total arrears compared to 75.8 percent in 2015.

In order to alleviate the liquidity deficit problem for private sector suppliers, the Ministry of Finance started issuing government promissory notes in March 2016 to cover their outstanding arrears with a monthly average of ILS 60–70 million (around USD 17–20 million). Each note has a six-month term. These notes were issued according to the dates of private sector claims and the volume of arrears. At the same time, the government has begun to build a reserve to cover the recovery of promissory notes (bank deposits) due later in 2016. Later, the banking sector began to clear these notes from private sector borrowers. From the time they were issued until the end of 2016, the value of these notes reached

(31) The maximum credit granted to a single borrower must not exceed 10 percent of the bank’s capital, and it may reach 25 percent with the prior approval of the PMA. As for the concentration limit, credit granted to any economic sector must not exceed 20 percent of the total credit according to the PMA’s instructions.


Although the concept of a single borrower limit does not apply to the government, the PMA has succeeded in closely monitoring and preventing this concentration through a friendly understanding with the banking sector according to which credit granted to the government would not exceed 100 percent of ownership equity. By the end of 2016, government credit to bank ownership equity dropped to 84.2 percent compared to 99.2 percent in 2015.

At the same time, credit granted to public sector employees is the second main factor that exposes the banking sector to the public sector, given that developments in these credits are directly related to developments in the budget. By the end of 2016, credit granted to these employees witnessed a 26.6 percent increase compared to 2015. Therefore, this type of credit accounted for 18.9 percent of total credit granted and 77.2 percent of ownership equity in 2016, compared to 17.6 percent and 70.1 percent in 2015.

Credit granted to private sector companies under government contract is the third channel of inherent risk, especially given that the regular payments by the government to private sector suppliers depends mainly on available liquidity. Moreover, the government’s inability to pay could undermine the financial position of private sector suppliers and force them to borrow from banks to settle their business payments. Thus, the ability of banks to collect their debt depends on the payment by the government of outstanding payments to suppliers, which in turn depends on the government having sufficient funds to pay. In 2016, the arrears of private sector companies under government contract increased by 10.3 percent compared to 2015. Moreover, these arrears amounted to 78.0 of total arrears compared to 75.8 percent in 2015.

In order to alleviate the liquidity deficit problem for private sector suppliers, the Ministry of Finance started issuing government promissory notes in March 2016 to cover their outstanding arrears with a monthly average of ILS 60–70 million (around USD 17–20 million). Each note has a six-month term. These notes were issued according to the dates of private sector claims and the volume of arrears. At the same time, the government has begun to build a reserve to cover the recovery of promissory notes (bank deposits) due later in 2016. Later, the banking sector began to clear these notes from private sector borrowers. From the time they were issued until the end of 2016, the value of these notes reached

(31) The maximum credit granted to a single borrower must not exceed 10 percent of the bank’s capital, and it may reach 25 percent with the prior approval of the PMA. As for the concentration limit, credit granted to any economic sector must not exceed 20 percent of the total credit according to the PMA’s instructions.


ILS 607.6 million, ILS 451 million of which were paid. Outstanding payments dropped to ILS 232 million and banks provided ILS 441 million in liquidity.

Undoubtedly, the credibility of the government promissory notes program depends (to a very large extent) on the government’s commitment to pay due notes and prevent any possible risks which could arise from non-payment or delay in payment for banks, because this will help maintain financial stability.

In fact, the PMA plays a pivotal role in managing risks that may arise from the public sector, through continuous, close, and effective risk-based monitoring. On the one hand, the PMA keeps watching the developments in public finances, especially liquidity and its repercussions on the banking system. On the other hand, it monitors the development of these risks through semi-annual stress testing. The results of such tests indicate that the ratio of banks’ capital to their risk-weighted assets remains higher than the minimum limit set by the PMA (12 percent) and by the Basel Committee (8 percent).

2. Exposures to Private Sector

In general, the Palestinian banking sector focuses on the private sector, to stimulate economic growth. In this context, this sector accounted for 98.8 percent of the banking sector’s total credits and amounted to USD 5.5 billion,32 a 24.7 percent increase compared to 2015. Consequently, its relative importance increased to 79.4 percent of total credits compared to 75.1 percent in 2015. This portfolio also accounted for 38.4 percent of total bank assets compared to 34.7 percent last year, and 40.7 percent of the GDP compared to 34.5 percent by the end of 2015.

In general, the private sector’s credits grew significantly over the past years, even more than economic activity. Between 2010 and 2016, it achieved average annual growth rates 3 times higher than real GDP growth. The average annual growth rate of this credit portfolio reached 19.3 percent whereas the average annual growth rate of the real GDP33 was estimated at 5.2 percent. This increase in credits is a direct result of the PMA’s efforts to promote the indicators of financial depth in the Palestinian economy, and the measures it adopted to strengthen the banking system’s infrastructure. Yet, this channel remains vulnerable to the effect of security and political developments on economic activity and their direct impact on the investment climate. In such circumstances, this channel is exposed to many risks resulting from default in payment and the borrower’s inability to fully or partially meet their obligation (interest or loan

(32) Distributed mostly between companies with 49.2 percent of these credits, individuals with 49.2 percent, credit cards with 1.3 percent, and the remaining 1.3 percent for non-profit institutions serving households).

(33) It is worth noting that nominal GDP growth reached 9.4 percent over the same period.


principal or both) on time. This may cause financial losses that adversely affect bank revenues and capital, which in turn may have an impact on asset quality.

In this context, the PMA monitors and follows up on all developments that may occur in credit risks, such as an increasing concentration and other risks. Therefore, it has adopted several precautionary measures and regulations (effective risk-based monitoring of the banking sector, and ongoing development of the Credit Information System34), all of which help banks in granting more credit, reduce associated risk to the lowest possible level, and shield the economy in general and the banking sector in particular against the adverse impacts of such risks.

To this end, and in order to identify all problems related to credit asset quality (the most important component of assets), the PMA uses a set of indicators, of which the most notable is the ratio of non-performing loans (NPLs) to total assets. The increase in this indicator indicates that the quality of the credits is deteriorating, and its risk level is growing, especially as it is closely related to political and economic developments in general. For example, the payment of loan installments granted to government employees depends to a large extent on the financial situation of the government, its stability and commitment to pay its employees’ salaries.

Moreover, the payment of loan installments granted to private sector companies and institutions contracted by the government depends to a certain extent on the government’s commitment to meet its obligations vis-à-vis these companies and institutions.

This in turn hinges on the stability of the government’s financial situation. If the financial situation is unstable, and payments by the government are irregular, the ability of these employees and companies to pay their installments will be at risk.

(34) In this regard, the PMA was released, the fourth version of this system in April 2016, that included more information and disclosure data.



According to data from banks operating in Palestine, the ratio of NPLs to total loans was nearly stable in 2016 compared to the previous year and was estimated at 2.18 percent compared to 2.14 percent in 2015. This ratio is one of the lowest in the region, compared to 7.6 percent in Morocco, 6.1 percent in UAE, 5.9 percent in Bahrein, 5.8 percent in Egypt, 5.2 percent in Sudan, 4.9 percent in Lebanon, 4.8 percent in Jordan, and 1.2 percent in Saudi Arabia.35

Source: AMF, Financial Soundness Indicators, 2016.

(35) Financial Soundness Indicators in the Arab Countries, Arab Monetary Fund, 2017.

Chart 5: NPLs to total Loans, 2012–2016

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Chart 5: NPLs to total Loans, Selected Arab Countries 2016

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principal or both) on time. This may cause financial losses that adversely affect bank revenues and capital, which in turn may have an impact on asset quality.

In this context, the PMA monitors and follows up on all developments that may occur in credit risks, such as an increasing concentration and other risks. Therefore, it has adopted several precautionary measures and regulations (effective risk-based monitoring of the banking sector, and ongoing development of the Credit Information System34), all of which help banks in granting more credit, reduce associated risk to the lowest possible level, and shield the economy in general and the banking sector in particular against the adverse impacts of such risks.

To this end, and in order to identify all problems related to credit asset quality (the most important component of assets), the PMA uses a set of indicators, of which the most notable is the ratio of non-performing loans (NPLs) to total assets. The increase in this indicator indicates that the quality of the credits is deteriorating, and its risk level is growing, especially as it is closely related to political and economic developments in general. For example, the payment of loan installments granted to government employees depends to a large extent on the financial situation of the government, its stability and commitment to pay its employees’ salaries.

Moreover, the payment of loan installments granted to private sector companies and institutions contracted by the government depends to a certain extent on the government’s commitment to meet its obligations vis-à-vis these companies and institutions.

This in turn hinges on the stability of the government’s financial situation. If the financial situation is unstable, and payments by the government are irregular, the ability of these employees and companies to pay their installments will be at risk.

(34) In this regard, the PMA was released, the fourth version of this system in April 2016, that included more information and disclosure data.





(35) Financial Soundness Indicators in the Arab Countries, Arab Monetary Fund, 2017.


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Chart 5: NPLs to total Loans, Selected Arab Countries 2016

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____________________ (35) Financial Soundness Indicators in the Arab Countries, Arab Monetary Fund, 2017.


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Chart 5A: NPLs to total Loans, Selected Arab Countries 2016

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This low percentage reflects the efficiency in decision-making with regard to credit, especially in light of the introduction of a concept of effective risk-based bank supervision and the ongoing development of credit information systems, which have had a clear impact on reducing credit risks and improving the quality of credit.

On another note, in a reference to the willingness and ability of banks to face and cover credit risks, and thus promote financial stability, banks increased their allocations to non-performing loans in 2016 by 19.1 percent compared to 2015, enough to cover 66.8 percent of non-performing loans compared to 67.3 percent in 2015. This slight decline in coverage was due to the fact that the rise in non-performing credit was higher than the increase in allocations. Non-performing loans grew by 20.0 percent compared to a 19.1 percent increase in allocations.


In the same vein, a structural analysis of NPLs based on default time periods shows that the relative importance of substandard loans36 to total non-performing loans increased from 9.1 percent in 2015 to 15.7 percent in 2016. Meanwhile, doubtful loans also increased from 8.3 percent to 13.8 percent, whereas loans classified as losses dropped from 82.6 percent to 70.5 percent by the end of 2016.

(36) Pursuant to PMA instruction No. 1/2008, facilities which are 91 to 180 days overdue are classified as substandard facilities and require allocations of 20 percent of their value. Facilities which are 181 to 360 days overdue are classified as doubtful facilities and require allocations of 50 percent of their value. Facilities that are overdue by more than 360 days are classified as losses and require allocations of 100 percent of their value.

Chart 6: Provision coverage for NPLs, 2012–2016

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This low percentage reflects the efficiency in decision-making with regard to credit, especially in light of the introduction of a concept of effective risk-based bank supervision and the ongoing development of credit information systems, which have had a clear impact on reducing credit risks and improving the quality of credit.

On another note, in a reference to the willingness and ability of banks to face and cover credit risks, and thus promote financial stability, banks increased their allocations to non-performing loans in 2016 by 19.1 percent compared to 2015, enough to cover 66.8 percent of non-performing loans compared to 67.3 percent in 2015. This slight decline in coverage was due to the fact that the rise in non-performing credit was higher than the increase in allocations. Non-performing loans grew by 20.0 percent compared to a 19.1 percent increase in allocations.


In the same vein, a structural analysis of NPLs based on default time periods shows that the relative importance of substandard loans36 to total non-performing loans increased from 9.1 percent in 2015 to 15.7 percent in 2016. Meanwhile, doubtful loans also increased from 8.3 percent to 13.8 percent, whereas loans classified as losses dropped from 82.6 percent to 70.5 percent by the end of 2016.

(36) Pursuant to PMA instruction No. 1/2008, facilities which are 91 to 180 days overdue are classified as substandard facilities and require allocations of 20 percent of their value. Facilities which are 181 to 360 days overdue are classified as doubtful facilities and require allocations of 50 percent of their value. Facilities that are overdue by more than 360 days are classified as losses and require allocations of 100 percent of their value.

Chart 6: Provision coverage for NPLs, 2012–2016

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The road ahead for monetary policy The PMA assumes several responsibilities usually assigned to central banks: its main goals consist of the following37

1. Maintaining monetary stability by targeting low and relatively steady inflation rates (as a primary goal);

2. Ensuring the stability of the financial system, composed of the banking and the non-banking financial sectors (as a secondary goal);

3. Promoting economic growth and lowering unemployment rates by implementing government’s general economic policies particularly with respect to public finance (the budget), employment and structural reform (if these aims do not interfere with the primary and the secondary goals).

Monetary policy framework and its efficiency The PMA serves a broad range of central banking functions as envisaged in the Paris Protocol. However, the PMA monetary policy framework is still limited, since the PMA does not issue its own currency. In line with its main objective to secure the stability of the banking and monetary system, the PMA does not refinance banks or act as lender of last resort but provides liquidity support to banks in certain cases.

Without a domestic currency, the available policy tools are limited and mainly used for prudential purposes. The PMA has no control over the domestic money

____________________ (37) Article 5 of Law No. 2 of 1997 of the Palestine Monetary Authority.

Chart 7: Structure of NPLs, 2012–2016

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supply and little influence over domestic interest rates and inflation. Because of the lack of a domestic money market, domestic government securities38 and a yield curve, it does not conduct open market operations. However, the PMA can influence the economy through its prudential regulations and related policy tools such as (i) reserve requirements, and (ii) placement of reserves at commercial banks to support liquidity.

Therefore, the credit channel is the main transmission channel of monetary policy. Due to the limited set of policy instruments, monetary policy has virtually no influence on exchange rates, interest rates, and asset prices. However, it can influence the credit supply to the private sector by altering the incentives for bank lending and for the composition of banks’ loan portfolios.

Conclusion In line with the PMA’s main objectives, it is worth mentioning that the PMA pays great attention to banking sector stability, through continuous assessment of the risks that undermine it and the mitigation of the effects and implications of such risks. The PMA promotes the use of effective risk-based banking monitoring within the modern regulatory framework; provides a robust payment and credit structures; monitors compliance with laws and regulations, particularly governance instructions and the AML/CFT Law; reinforces oversight and regulatory frameworks to implement Basel II standards; and promotes the use of a wide range of prudential limits and ceilings including the required reserves ratios and the requirement for minimum capital and liquidity ratios. Also the PMA restricts credit concentration, placements abroad and currency fluctuations and adopts rules that accord with the recommendations and principles of Basel Committee, corporate governance and best practices of mergers and acquisitions.

In fact, many international institutions (including the IMF and the World Bank) have commended the PMA’s good management in this regard.

____________________ (38) The development of a domestic securities market would expand the financing options. Domestic

financing options are currently very limited, as government debt is not securitized and not held by the general public, so establishing a market for securitized government debt would help deepen the financial market, and over time, provide the Government with more flexible and modern financing options.


105

supply and little influence over domestic interest rates and inflation. Because of the lack of a domestic money market, domestic government securities38 and a yield curve, it does not conduct open market operations. However, the PMA can influence the economy through its prudential regulations and related policy tools such as (i) reserve requirements, and (ii) placement of reserves at commercial banks to support liquidity.

Therefore, the credit channel is the main transmission channel of monetary policy. Due to the limited set of policy instruments, monetary policy has virtually no influence on exchange rates, interest rates, and asset prices. However, it can influence the credit supply to the private sector by altering the incentives for bank lending and for the composition of banks’ loan portfolios.

Conclusion In line with the PMA’s main objectives, it is worth mentioning that the PMA pays great attention to banking sector stability, through continuous assessment of the risks that undermine it and the mitigation of the effects and implications of such risks. The PMA promotes the use of effective risk-based banking monitoring within the modern regulatory framework; provides a robust payment and credit structures; monitors compliance with laws and regulations, particularly governance instructions and the AML/CFT Law; reinforces oversight and regulatory frameworks to implement Basel II standards; and promotes the use of a wide range of prudential limits and ceilings including the required reserves ratios and the requirement for minimum capital and liquidity ratios. Also the PMA restricts credit concentration, placements abroad and currency fluctuations and adopts rules that accord with the recommendations and principles of Basel Committee, corporate governance and best practices of mergers and acquisitions.

In fact, many international institutions (including the IMF and the World Bank) have commended the PMA’s good management in this regard.

____________________ (38) The development of a domestic securities market would expand the financing options. Domestic

financing options are currently very limited, as government debt is not securitized and not held by the general public, so establishing a market for securitized government debt would help deepen the financial market, and over time, provide the Government with more flexible and modern financing options.



The State of Kuwait

Ms. Abeer A. Alsabti

Deputy Manager of Economic Research

Central Bank of Kuwait



Monetary Policy Implementation in Kuwait Introduction

A discussion of Kuwait monetary policy needs, of necessity, to be viewed within the context defined by Kuwait’s being a small open economy with no barriers to inward or outward movement of capital and a framework of the exchange rate in which the national currency is pegged to an undisclosed basket of selected international currencies. Within these aspects, Kuwait monetary policy pursues price stability as its main objective. In addition to the primary mandate of price stability, monetary policy in Kuwait is also expected to foster economic growth through creating conditions that support a business and investment-friendly environment conducive to growth, especially that of the private sector.

This paper discusses monetary policy operation in Kuwait, with emphasis on developments in money and exchange rate markets in recent years. The paper is organized as follows. Following this introduction in Section I, Section II addresses monetary policy. Section III is devoted to the exchange rate developments. A brief conclusion is provided in Section IV.

I. Monetary Policy

Monetary policy in Kuwait is set and implemented by the Central Bank of Kuwait (CBK) in accordance with the Law No. 32 of the year 1968 concerning Currency, the Central Bank of Kuwait and the Organization of Banking Business. Its primary objective is to maintain monetary stability through the use of direct and indirect monetary policy instruments to keep inflation, both domestic and imported, in check. A related objective mandated by the Law is that monetary policy is conducted in such a manner as to assist the social and economic progress and the growth of national income.

The primary tool of monetary policy is the discount rate to which are linked, within specified margins, the maximum limits of interest rates on Kuwaiti dinar (KWD) lending transactions at the banking and financial system units of the country. Other tools that the CBK has at its disposal include direct intervention in the money market through taking/placing deposits, issuance of public debt instruments, issuance of CBK Bonds, REPOs, etc.

The CBK strives to ensure that the discount rate is set at a level where local interest rates remain consistent with domestic economic conditions as well as interest rates on major international currencies, especially the US dollar (USD)


Monetary Policy Implementation in Kuwait Introduction

A discussion of Kuwait monetary policy needs, of necessity, to be viewed within the context defined by Kuwait’s being a small open economy with no barriers to inward or outward movement of capital and a framework of the exchange rate in which the national currency is pegged to an undisclosed basket of selected international currencies. Within these aspects, Kuwait monetary policy pursues price stability as its main objective. In addition to the primary mandate of price stability, monetary policy in Kuwait is also expected to foster economic growth through creating conditions that support a business and investment-friendly environment conducive to growth, especially that of the private sector.

This paper discusses monetary policy operation in Kuwait, with emphasis on developments in money and exchange rate markets in recent years. The paper is organized as follows. Following this introduction in Section I, Section II addresses monetary policy. Section III is devoted to the exchange rate developments. A brief conclusion is provided in Section IV.

I. Monetary Policy

Monetary policy in Kuwait is set and implemented by the Central Bank of Kuwait (CBK) in accordance with the Law No. 32 of the year 1968 concerning Currency, the Central Bank of Kuwait and the Organization of Banking Business. Its primary objective is to maintain monetary stability through the use of direct and indirect monetary policy instruments to keep inflation, both domestic and imported, in check. A related objective mandated by the Law is that monetary policy is conducted in such a manner as to assist the social and economic progress and the growth of national income.

The primary tool of monetary policy is the discount rate to which are linked, within specified margins, the maximum limits of interest rates on Kuwaiti dinar (KWD) lending transactions at the banking and financial system units of the country. Other tools that the CBK has at its disposal include direct intervention in the money market through taking/placing deposits, issuance of public debt instruments, issuance of CBK Bonds, REPOs, etc.

The CBK strives to ensure that the discount rate is set at a level where local interest rates remain consistent with domestic economic conditions as well as interest rates on major international currencies, especially the US dollar (USD)


so that local banks’ ability to meet their customers’ funding needs is not impaired. CBK ensures that current liquidity conditions are supportive of credit demand, and monetary operations focus primarily on the absorption of surplus liquidity.

CBK’s monetary policy has been accommodative, that is maintaining generally low levels of interest, following the global financial crisis as manifested in a series of actions such as significant reduction in the discount rate which remained at just 2 percent from October 2012 up to December 2015 when it was raised by 25 basis points to keep it in line with the U.S. Federal Funds rate.

The CBK again raised its discount rate by 25 basis points in December 2016 and by a further 25 basis points in March 2017 following increases in the U.S. Federal Funds target rate. However, unlike central banks in other GCC countries, the CBK kept its policy rate at 2.75 percent despite the Fed’s hike of 25 basis points in June of this year. Part of this relatively modest flexibility stems from the fact that the KWD is pegged to an undisclosed basket of currencies comprising several important international currencies. Chart 1 shows the evolution of CBK discount rate from January 2014 to December 2016(39).

39 All data reported in this paper are from the CBK.

)%(

Chart 1: CBK Discount Rates (2014 – 2016)


Money Market Developments

Liquidity absorption and interbank rate data indicate that liquidity conditions eased towards the end of 2016, partially due to a recovery of oil prices following OPEC’s decision to cut production. Public debt worth KWD 2.95 billion was issued in 2016 which raised the balance of public debt instruments from KWD 1.6 billion at the end of 2015 to KWD 3.3 billion at the end of 2016. This increased investment in government securities has helped the banking sector to diversify their investment portfolio by investing more in domestic public debt, contributing thereby to the development of a liquid local currency debt market. The capacity of the banking sector to absorb government debt without crowding out private credit of course however had been a concern. To counter any risk of private sector crowding out, CBK has closely worked with the Ministry of Finance to limit government borrowing from domestic banks within an acceptable range.

The recent raises in discount rate don’t appear to have any perceivable impact on credit growth. The spread between the weighted average lending rate and the weighted average deposit rate on private sector KWD deposits was affected only marginally – from 2.83 percentage points at the end of 2015 to 2.90 percentage points at the end of 2016, apparently brought about by a marginal improvement in the weighted average deposit rate while the lending rate remained flat.

The KWD interbank offered rate started the year 2016 on a rising trend, which however tapered off towards the end of the year. Interbank one-month offered rate closed the year at 1.1 percentage points, perceptibly lower than its 2015 closing at 1.4 percentage points.

Liquidity absorption by the CBK decreased in the last quarter of 2016 (KD 2.685 billion) compared with its level in the corresponding period of 2015 (KD 2.995 billion), mostly brought about by a decrease in the issuance of CBK Bonds and related Tawarruq. The overall new issue of three-month and six-month CBK Bonds and related Tawarruq declined by 11.5 percent during 2016 relative to 2015.


Money Market Developments

Liquidity absorption and interbank rate data indicate that liquidity conditions eased towards the end of 2016, partially due to a recovery of oil prices following OPEC’s decision to cut production. Public debt worth KWD 2.95 billion was issued in 2016 which raised the balance of public debt instruments from KWD 1.6 billion at the end of 2015 to KWD 3.3 billion at the end of 2016. This increased investment in government securities has helped the banking sector to diversify their investment portfolio by investing more in domestic public debt, contributing thereby to the development of a liquid local currency debt market. The capacity of the banking sector to absorb government debt without crowding out private credit of course however had been a concern. To counter any risk of private sector crowding out, CBK has closely worked with the Ministry of Finance to limit government borrowing from domestic banks within an acceptable range.

The recent raises in discount rate don’t appear to have any perceivable impact on credit growth. The spread between the weighted average lending rate and the weighted average deposit rate on private sector KWD deposits was affected only marginally – from 2.83 percentage points at the end of 2015 to 2.90 percentage points at the end of 2016, apparently brought about by a marginal improvement in the weighted average deposit rate while the lending rate remained flat.

The KWD interbank offered rate started the year 2016 on a rising trend, which however tapered off towards the end of the year. Interbank one-month offered rate closed the year at 1.1 percentage points, perceptibly lower than its 2015 closing at 1.4 percentage points.

Liquidity absorption by the CBK decreased in the last quarter of 2016 (KD 2.685 billion) compared with its level in the corresponding period of 2015 (KD 2.995 billion), mostly brought about by a decrease in the issuance of CBK Bonds and related Tawarruq. The overall new issue of three-month and six-month CBK Bonds and related Tawarruq declined by 11.5 percent during 2016 relative to 2015.


Issuance of Treasury Bonds and related Tawarruq witnessed a significant rise in 2016, with KWD 1.640 billion worth Treasury Bonds and KWD 1.310 billion worth its Sharia-compliant equivalents issued. This was particularly favorable for the Islamic banks which typically have inadequate opportunities to invest in risk-free government papers. Chart 3 shows CBK Bond/Tawarruq issuance from January 2015 to December 2016.

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Chart (3): CBK Bond/ Tawarruq Issuance (2015 – 2016)


Exchange Rate Policy

Fundamentally sustainable economic performance and appropriate macro policies – both fiscal and monetary – constitute the pillars of exchange rate stability. More specifically the maintenance of the competitiveness and attractiveness of the KWD as the store for domestic savings and investment remain the highest priority for the CBK which remains committed to taking all actions necessary to safeguard the competitiveness of the national currency.

The current exchange rate regime of the KWD was introduced initially on 18 March 1975 which continued until the end of the year 2002 and – following a brief period of pegging to the USD – was subsequently reintroduced on 20 May 2007. It is based on pegging the KWD exchange rate to a special weighted basket of currencies of countries that share financial and trade relations with Kuwait. This basket peg helps reduce imported inflationary pressures, ensures the reasonable stability of the KWD exchange rate vis-à-vis major world currencies, allows for some flexibility in monetary policy, and provides a nominal anchor in the pursuit of price stability.

Developments in 2016:

Although the KWD/USD exchange rate remained fairly stable throughout 2016 with fluctuations remaining mostly within a range of ±0.2 percent, it closed the year by depreciating by 0.9 percent. This relative appreciation of the USD vis-à-vis the KWD was however modest compared with its appreciation against other major international currencies such as the euro, pound sterling, and the Japanese yen.

Chart 4 shows the 2016 exchange rates vis-à-vis the U.S. dollar of the euro, pound sterling, Japanese yen, and the Kuwaiti dinar. It is observed that, except for the euro, the two other major currencies depreciated perceptibly around the end of the year. Notable too is that the Kuwaiti dinar exchange rate has been reasonably stable which contrasts sharply with the wild volatility exhibited by the other exchange rates.


Exchange Rate Policy

Fundamentally sustainable economic performance and appropriate macro policies – both fiscal and monetary – constitute the pillars of exchange rate stability. More specifically the maintenance of the competitiveness and attractiveness of the KWD as the store for domestic savings and investment remain the highest priority for the CBK which remains committed to taking all actions necessary to safeguard the competitiveness of the national currency.

The current exchange rate regime of the KWD was introduced initially on 18 March 1975 which continued until the end of the year 2002 and – following a brief period of pegging to the USD – was subsequently reintroduced on 20 May 2007. It is based on pegging the KWD exchange rate to a special weighted basket of currencies of countries that share financial and trade relations with Kuwait. This basket peg helps reduce imported inflationary pressures, ensures the reasonable stability of the KWD exchange rate vis-à-vis major world currencies, allows for some flexibility in monetary policy, and provides a nominal anchor in the pursuit of price stability.

Developments in 2016:

Although the KWD/USD exchange rate remained fairly stable throughout 2016 with fluctuations remaining mostly within a range of ±0.2 percent, it closed the year by depreciating by 0.9 percent. This relative appreciation of the USD vis-à-vis the KWD was however modest compared with its appreciation against other major international currencies such as the euro, pound sterling, and the Japanese yen.

Chart 4 shows the 2016 exchange rates vis-à-vis the U.S. dollar of the euro, pound sterling, Japanese yen, and the Kuwaiti dinar. It is observed that, except for the euro, the two other major currencies depreciated perceptibly around the end of the year. Notable too is that the Kuwaiti dinar exchange rate has been reasonably stable which contrasts sharply with the wild volatility exhibited by the other exchange rates.


CBK’s substantial holdings of foreign assets may be viewed as one of the factors contributing to the stability of the KWD exchange rate. At the end of 2016, CBK’s foreign assets stood at KWD 8.7 billion (USD 28.4 billion), equivalent to almost 6.2 months of imports. Conclusion Monetary policy in Kuwait remains accommodative, with inflation subdued. One has to keep in mind, however, that there is a limit to what monetary policy alone can do and we are probably not very far from that limit. Hence fiscal and structural policies are called for properly addressing future challenges. Also, the present status quo of Kuwait monetary policy may be disrupted by external events. To consider one scenario, if the target Federal Funds rate is raised further there may be a need to revise CBK’s discount rate. The present policy of pegging the KWD exchange rate to a basket of currencies has served the country well, delivering monetary policy credibility and low inflation. Given the structure of the Kuwaiti economy which is characterized by heavy reliance on a single commodity, there is no need for, or benefits to derive from changing the current exchange rate regime.

Chart (4): Exchange Rates Vis – á – Vis the USD (2016) (normalized mean = 1.0)

0.88

0.91

0.94

0.97

1.00

1.03

1.06

1.09

1.12

Japanese Yen Pound Sterling Kuwait Dinar Euro

Q1 2016 Q2 2016 Q3 2016 Q4 2016



The Republic of Lebanon

H.E. Dr. Saad Andary

Vice-Governor Banque Du Liban

Abu Dhabi, United Arab Emirates 15–16 th November 2017


Monetary Policy Implementation in Lebanon General Overview The past few years have strained the Lebanese economy with the regional conditions, caused particularly by the spillover risks from the Syrian crisis. The situation was also exacerbated by the political paralysis which kept the country without a president for more than two years. As a result, the main economic indicators, namely foreign trade, tourism, investment, and consumption, have been declining since 2011. Despite these challenges, confidence in the economy and the Lebanese pound remained strong, with a real GDP growth of around 2% and inflation close to zero percent in 2016.

Based on the aforementioned, and in light of the persisting global economic stagnation and regional conditions, the Banque du Liban (BDL) has resorted to additional financial measures as part of its monetary policy objectives. BDL has deployed all its efforts to ensure that its main objectives, namely, to safeguard monetary and economic stability in addition to increasing the Lebanese national wealth, are continuously met.

The recent financial swaps, launched by BDL between May and August 2016, have had a positive impact on both the monetary and banking fronts. BDL’s foreign assets reached a historic record level of more than USD 41 billion, thus conferring stability to the Lebanese pound and interest rates. The balance of payments has recorded a surplus of USD 1.3 billion in 2016.

The banking sector, in turn, has proven its worth despite the pressing challenges that took some toll on its advancement. However, its performance remains healthy and enduring: total banking activity grew by more than 9% with total assets of banks exceeding USD 204 billion in December 2016. Total deposits have increased by around 8% to reach a new high of USD 172 billion at end-2016, with additional funds of around USD 10 billion entering the banking sector. Lending activity recorded a 5.4% growth during 2016, with total credit to the private sector exceeding USD 58 billion in December 2016. The deposit dollarization ratio registered a slight increase, reaching 65.8%, while the loan dollarization ratio continued its downward trend to reach 72% at end-2016, its lowest recorded so far.


Monetary Policy Implementation in Lebanon General Overview The past few years have strained the Lebanese economy with the regional conditions, caused particularly by the spillover risks from the Syrian crisis. The situation was also exacerbated by the political paralysis which kept the country without a president for more than two years. As a result, the main economic indicators, namely foreign trade, tourism, investment, and consumption, have been declining since 2011. Despite these challenges, confidence in the economy and the Lebanese pound remained strong, with a real GDP growth of around 2% and inflation close to zero percent in 2016.

Based on the aforementioned, and in light of the persisting global economic stagnation and regional conditions, the Banque du Liban (BDL) has resorted to additional financial measures as part of its monetary policy objectives. BDL has deployed all its efforts to ensure that its main objectives, namely, to safeguard monetary and economic stability in addition to increasing the Lebanese national wealth, are continuously met.

The recent financial swaps, launched by BDL between May and August 2016, have had a positive impact on both the monetary and banking fronts. BDL’s foreign assets reached a historic record level of more than USD 41 billion, thus conferring stability to the Lebanese pound and interest rates. The balance of payments has recorded a surplus of USD 1.3 billion in 2016.

The banking sector, in turn, has proven its worth despite the pressing challenges that took some toll on its advancement. However, its performance remains healthy and enduring: total banking activity grew by more than 9% with total assets of banks exceeding USD 204 billion in December 2016. Total deposits have increased by around 8% to reach a new high of USD 172 billion at end-2016, with additional funds of around USD 10 billion entering the banking sector. Lending activity recorded a 5.4% growth during 2016, with total credit to the private sector exceeding USD 58 billion in December 2016. The deposit dollarization ratio registered a slight increase, reaching 65.8%, while the loan dollarization ratio continued its downward trend to reach 72% at end-2016, its lowest recorded so far.


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The Lebanese banking sector’s high levels of liquidity enable commercial banks to finance the government and private sector needs while maintaining a stable interest rate structure. In terms of capitalization, banks’ capital base has exceeded USD 18 billion in December 2016, with an annual growth rate of 9%, which enables banks to comply with the new international capital, risk and IFRS requirements.

Chart (1): Total Private Sector Deposits of Commercial Banks (Millions of USD)

Chart (2): Total Banks’ Loans to the Private Sector (Millions of USD)


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II. The Operational Framework of Monetary Policy in Lebanon: Objectives, Instruments, and Transmission Mechanisms BDL’s mandate includes safeguarding the national currency and maintaining financial and economic stability. Its main functions consist of the issuance of the national currency, regulating the money supply, controlling interest rates, setting the monetary policy, and overseeing and developing the banking and financial sectors. BDL’s policies are considered the foundation for sustained social and economic growth in Lebanon, as much as for the development of the banking sector. Lebanon’s banking sector is considered one of the strongest sectors of the Lebanese economy.

In order to fulfill its mandate, and particularly safeguarding monetary and economic stability, the BDL resorts to conventional tools, as well as to nonconventional ones when need be.

A. Conventional Monetary Policy Tools

For the past two decades, BDL’s monetary policy has been first and foremost targeted at stabilizing the Lebanese pound exchange rate and controlling inflation. The Central bank’s continuous commitment to a stable exchange rate has proved to be the key to the stability of the financial system.

Chart (3): Commercial Banks’ Equity (millions of USD)


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II. The Operational Framework of Monetary Policy in Lebanon: Objectives, Instruments, and Transmission Mechanisms BDL’s mandate includes safeguarding the national currency and maintaining financial and economic stability. Its main functions consist of the issuance of the national currency, regulating the money supply, controlling interest rates, setting the monetary policy, and overseeing and developing the banking and financial sectors. BDL’s policies are considered the foundation for sustained social and economic growth in Lebanon, as much as for the development of the banking sector. Lebanon’s banking sector is considered one of the strongest sectors of the Lebanese economy.

In order to fulfill its mandate, and particularly safeguarding monetary and economic stability, the BDL resorts to conventional tools, as well as to nonconventional ones when need be.

A. Conventional Monetary Policy Tools

For the past two decades, BDL’s monetary policy has been first and foremost targeted at stabilizing the Lebanese pound exchange rate and controlling inflation. The Central bank’s continuous commitment to a stable exchange rate has proved to be the key to the stability of the financial system.

Chart (3): Commercial Banks’ Equity (millions of USD)


1. Maintaining Exchange Rate Stability

After the deterioration of the Lebanese pound (LBP) during the 1980s and early 1990s, the Banque du Liban has realized that maintaining monetary stability using the exchange rate as a nominal anchor is an essential prerequisite for financial stability. The BDL has followed a managed exchange rate regime, keeping the LBP/USD within a narrow band that has been set at LBP 1501–1514 to the dollar. A gradual appreciation of the Lebanese pound was recorded over the 1992–1999 period, followed by relative stability since then. Drastic price containment came along with exchange rate appreciation.

2. Maintaining Low Rates of Inflation

The three-digit inflation rate that crippled the Lebanese economy in the early 90s has been successfully contained at a single-digit rate over the past twenty years. Currently, the inflation rate is maintained below 4%, which is in line with BDL’s economic objectives.

3. Ensuring a Gradual Decrease in the Interest Rates

The BDL’s compliance with market tendencies in the determination of interest rates maintained the latter at appropriate levels to spur capital inflows and strengthen the external position. Growing confidence in the local currency has resulted in gradual interest rate cuts since the 90s. The massive cash injection into the Lebanese market during 2008–2010 also helped the interest rate structure to decline further; which resulted in debt service savings over the past years. The BDL is aiming to maintain stability in interest rates considering that these rates have reached a well-balanced level paving the way for good growth and productive investments.

Chart (4): Inflation Rate Exchange Rate Change


B. Nonconventional Monetary Policy Tools

The pressing regional and local challenges that have hindered the Lebanese economy for the past few years have incited the BDL to resort to unconventional monetary policy tools in order to boost economic and social development.

1. Stimulus Packages

The BDL launched its first stimulus package amounting to USD1.47 billion back in 2013. These credit incentives, provided through the banking sector, have played a key role in boosting and supporting the numerous segments of the Lebanese economy: fostering traditional sectors through productive loans; development of human capital and entrepreneurship through education, research and development and knowledge and innovation loans; reinforcement of the middle class through housing loans; and preservation of the environment through green incentives.

During the past five years, the cumulative packages have amounted to USD 5 billion and have benefited productive sectors (35 percent) and the housing sector (65 percent). These incentives, together with the exemption of banks from reserve requirements and government loan subsidies, have led to the injection of almost USD 14 billion to support economic activity since 2009.

The importance of these catalyst endeavors lies in their sizable contribution to real GDP, and their momentum in job creation.

Chart (5): Primary Market Rates on Treasury Bills


B. Nonconventional Monetary Policy Tools

The pressing regional and local challenges that have hindered the Lebanese economy for the past few years have incited the BDL to resort to unconventional monetary policy tools in order to boost economic and social development.

1. Stimulus Packages

The BDL launched its first stimulus package amounting to USD1.47 billion back in 2013. These credit incentives, provided through the banking sector, have played a key role in boosting and supporting the numerous segments of the Lebanese economy: fostering traditional sectors through productive loans; development of human capital and entrepreneurship through education, research and development and knowledge and innovation loans; reinforcement of the middle class through housing loans; and preservation of the environment through green incentives.

During the past five years, the cumulative packages have amounted to USD 5 billion and have benefited productive sectors (35 percent) and the housing sector (65 percent). These incentives, together with the exemption of banks from reserve requirements and government loan subsidies, have led to the injection of almost USD 14 billion to support economic activity since 2009.

The importance of these catalyst endeavors lies in their sizable contribution to real GDP, and their momentum in job creation.

Chart (5): Primary Market Rates on Treasury Bills


In the past year, the scope of the stimulus package has been expanded to respond to new market financing needs, by including new sectors such as production and artwork, and industrial exports.

2. Equity Financing and the Knowledge Economy

Supporting productive sectors is essential yet not sufficient alone to ground Lebanon’s economy in sustainable growth and development. Considering that the wealth of Lebanon lies in its pool of highly skilled labor, and aiming at being innovative itself, the BDL launched in August 2013 a new initiative enabling banks to contribute, for the first time, in equity financing of startup companies, incubators, accelerators and venture capital. Acknowledging the fact that strengthening the Lebanese knowledge economy improves the performance of all the economic sectors, creates job opportunities, increases GDP per capita and ensures sustainable development, BDL is encouraging banks to invest capital over a period of 7 years, in order to nurse these vital economic agents. Access to interest-free financial facilities will be provided to banks who participate in this initiative.

The BDL has placed more focus on further developing the Lebanese Knowledge Economy in 2016. It has increased the margin of funds that banks could dedicate to the financing of this sector, by authorizing them to invest, with BDL’s guarantee, up to 4% of their own funds, compared to 3% previously.

To date, and after only three years of implementation and more than USD 600 million dedicated funding, the Lebanese knowledge economy has attracted 800 startups, created 6000 jobs, and increased the national wealth by around USD 1 Billion. This promising sector will soon account for more than 2% of GDP, and it is expected to grow by around 7–9% per year in the coming three years.

3. BDL’s Financial Operations

In the second half of 2016, the Lebanese economy was still struggling. As such, and in order to safeguard economic and financial stability, the BDL deemed it appropriate to pursue its unconventional monetary initiatives by adopting an additional multipurpose and multidimensional financial engineering scheme.

i. Phases.

The financial swap operations were conducted in three phases between May and August 2016 as follows:


Phase 1:

BDL swapped Lebanese pound Treasury bills (TBs) held in its portfolio with equivalent Eurobonds issued by the Ministry of Finance, amounting to USD 2 billion, at an interest rate ranging between 6.25 percent for a six-year period and 6.85 percent for a 13-year period.

Phase 2:

BDL sold the recently acquired Eurobonds and issued Dollar Certificates of Deposits (CDs) to commercial banks, investment banks, and financial institutions for an approximate amount of USD 11 billion, against fresh Dollar inflows transferred by banks and financial institutions from abroad.

Phase 3:

BDL discounted at zero percent financial instruments in Lebanese pounds (TBs and CDs) held by commercial banks, investment banks, and financial institutions in their portfolio, of an amount equivalent to the transaction, referred to in Phase 2 (Eurobonds and Dollar certificates of deposits). Half of the interest income that would have been realized during the life of the TBs and CDs till maturity was repaid to banks and financial institutions holding the TBs and CDs. This transaction was subject, among other conditions, to a 50 percent voluntary haircut on the interest in favor of Banque Du Liban.

ii. Impact.

These financial operations have a multipurpose and multidimensional impact that can be assessed by highlighting the following results:

First, strengthening BDL’s foreign-currency assets from the standpoint that a strong balance sheet is essential to preserve both domestic and external confidence, and hence its positive impact on the exchange rate and interest rate stability. Following the completion of these operations, BDL’s foreign-currency assets have reached a historical record high of USD 41 billion, a fact that confers stability to the Lebanese pound and interest rates.

Second, consolidating the capital base of banks. BDL instructed banks to book the income generated from these operations in their Tier 2 Capital. This would enable banks to build additional general provisions before implementing the IFRS 9 in January 2018, in a way to help counter any risks related to doubtful debts. To this end, BDL is targeting the formation of reserves at a ratio of two percent of risk-weighted assets, which translates approximately to USD 1.2


Phase 1:

BDL swapped Lebanese pound Treasury bills (TBs) held in its portfolio with equivalent Eurobonds issued by the Ministry of Finance, amounting to USD 2 billion, at an interest rate ranging between 6.25 percent for a six-year period and 6.85 percent for a 13-year period.

Phase 2:

BDL sold the recently acquired Eurobonds and issued Dollar Certificates of Deposits (CDs) to commercial banks, investment banks, and financial institutions for an approximate amount of USD 11 billion, against fresh Dollar inflows transferred by banks and financial institutions from abroad.

Phase 3:

BDL discounted at zero percent financial instruments in Lebanese pounds (TBs and CDs) held by commercial banks, investment banks, and financial institutions in their portfolio, of an amount equivalent to the transaction, referred to in Phase 2 (Eurobonds and Dollar certificates of deposits). Half of the interest income that would have been realized during the life of the TBs and CDs till maturity was repaid to banks and financial institutions holding the TBs and CDs. This transaction was subject, among other conditions, to a 50 percent voluntary haircut on the interest in favor of Banque Du Liban.

ii. Impact.

These financial operations have a multipurpose and multidimensional impact that can be assessed by highlighting the following results:

First, strengthening BDL’s foreign-currency assets from the standpoint that a strong balance sheet is essential to preserve both domestic and external confidence, and hence its positive impact on the exchange rate and interest rate stability. Following the completion of these operations, BDL’s foreign-currency assets have reached a historical record high of USD 41 billion, a fact that confers stability to the Lebanese pound and interest rates.

Second, consolidating the capital base of banks. BDL instructed banks to book the income generated from these operations in their Tier 2 Capital. This would enable banks to build additional general provisions before implementing the IFRS 9 in January 2018, in a way to help counter any risks related to doubtful debts. To this end, BDL is targeting the formation of reserves at a ratio of two percent of risk-weighted assets, which translates approximately to USD 1.2


billion. This would enable banks to attain the BDL targeted objective of a capital adequacy ratio of 15 percent by the end of 2018, way above the international capitalization requirements under Basel III.

Third, increasing liquidity in local currency, to secure the financing needs of the public and private sectors at optimal costs. This operation succeeded in achieving this goal through deposit growth, which reached 2.5 percent right after completing the financial operations, compared to 0.9 percent in the first four months of 2016. On an annual basis, deposits grew in 2016 by 8 percent. As a consequence, deposits at banks have risen from nearly USD 159 billion at end-2015 to nearly USD 172 billion at end-2016. Banks’ assets also increased from nearly USD 186 billion at end-2015 to nearly USD 204 billion at end-2016.

Owing to this newly injected liquidity in Lebanese pounds, banks will be able to continue expanding their credit portfolio, especially towards SMEs, to back the economic activity, while complying with the new international capital and risk requirements.

Fourth, improving the government debt profile by reducing the debt cost. BDL’s financial operations have led to the decline of the five-year TBs interest rate from 6.74 percent to five percent. Banque Du Liban has also reduced interest rates on long-term certificates of deposit and savings deposits in Lebanese pound from 9 percent to 8.4 percent. As a result of the government debt profile improvement, it was noted that international financial institutions have encouraged their customers (pension funds and asset managers) to invest in Lebanese Eurobonds. These operations have also improved Lebanon’s monetary situation, without resorting to an increase in interest rates on TBs issued in Lebanese pound or US Dollar, which was one of the proposals submitted by the IMF mission to reinforce BDL’s foreign-currency assets. If the IMF’s proposal had been adopted by BDL, it would have entailed an increase in the cost of servicing both the Lebanese pound and dollar-based public and private debt by around USD 1.3 billion annually for each interest rate increase of one percent.

Fifth, the success encountered by the latest sovereign issue confirms once more the persisting confidence in the Republic of Lebanon Eurobonds. The subscription demand was six-fold the amount issued (USD 17.8 billion against USD 3 billion), knowing that interest rates on the new Eurobonds issued are considered to be in line with those in the secondary market.

Banque Du Liban has taken the measures needed for the success of the latest subscription to the Eurobonds issued by the Ministry of Finance. This is based on its general mission specified in Article 70 of the Code of Money and Credit,


and also on Article 97 of the same code, in its capacity as the public sector’s financial agent empowered by law to help “free of charge, in marketing domestic and external borrowing by the public sector”. As such, Banque Du Liban has authorized banks to discount the certificates of deposit in US Dollar issued by BDL, provided the discounted amount is re-invested in the Republic of Lebanon Eurobonds.

Sixth, improving the balance of payments (BOP) status by adopting the means needed to boost internal demand and productivity, hence bolstering growth and development. This operation has led to inflows amounting to USD 4.2 billion at end-2016, thus transforming the BOP cumulative deficit of USD 1.7 billion in May 2016 into a cumulative surplus of USD 1.3 billion at the end of 2016.

Seventh, the inflation rate has risen from zero percent to two percent in September 2016, in line with BDL objectives.

Eighth, improving Lebanon’s credit rating as, despite the political deadlock prevailing in Lebanon when the financial engineering was launched, Standard & Poor’s upgraded Lebanon’s outlook from negative to stable.

III. Conclusion Since its inception, the Central Bank of Lebanon has been keen on safeguarding the national currency and maintaining financial and economic stability. And it never spared any efforts to ensure that the Lebanese economy in general and the financial sector in particular, are strong, sound and resilient.

The policies undertaken by the BDL, have proven their success and have been recognized as major drivers of the Lebanese economy. The BDL will remain vigilant to the financial and economic needs of Lebanon and will continue to be proactive in light of persisting challenges.

Nonetheless, to ensure sustainable development and to pave the way for real inclusive growth, the government needs to undertake a number of structural reforms: revamping infrastructure, enhancing the quality and quantity of public services, simplifying administrative procedures, enforcing fiscal discipline, reforming the energy sector, and passing the budget law, among others. The BDL has strived to create the adequate environment to promote the banking and financial sectors on the one hand, and the knowledge ecosystem on the other, with the expectation that the government would, in turn, support the creation of the necessary environment for cross-sectoral economic growth.


and also on Article 97 of the same code, in its capacity as the public sector’s financial agent empowered by law to help “free of charge, in marketing domestic and external borrowing by the public sector”. As such, Banque Du Liban has authorized banks to discount the certificates of deposit in US Dollar issued by BDL, provided the discounted amount is re-invested in the Republic of Lebanon Eurobonds.

Sixth, improving the balance of payments (BOP) status by adopting the means needed to boost internal demand and productivity, hence bolstering growth and development. This operation has led to inflows amounting to USD 4.2 billion at end-2016, thus transforming the BOP cumulative deficit of USD 1.7 billion in May 2016 into a cumulative surplus of USD 1.3 billion at the end of 2016.

Seventh, the inflation rate has risen from zero percent to two percent in September 2016, in line with BDL objectives.

Eighth, improving Lebanon’s credit rating as, despite the political deadlock prevailing in Lebanon when the financial engineering was launched, Standard & Poor’s upgraded Lebanon’s outlook from negative to stable.

III. Conclusion Since its inception, the Central Bank of Lebanon has been keen on safeguarding the national currency and maintaining financial and economic stability. And it never spared any efforts to ensure that the Lebanese economy in general and the financial sector in particular, are strong, sound and resilient.

The policies undertaken by the BDL, have proven their success and have been recognized as major drivers of the Lebanese economy. The BDL will remain vigilant to the financial and economic needs of Lebanon and will continue to be proactive in light of persisting challenges.

Nonetheless, to ensure sustainable development and to pave the way for real inclusive growth, the government needs to undertake a number of structural reforms: revamping infrastructure, enhancing the quality and quantity of public services, simplifying administrative procedures, enforcing fiscal discipline, reforming the energy sector, and passing the budget law, among others. The BDL has strived to create the adequate environment to promote the banking and financial sectors on the one hand, and the knowledge ecosystem on the other, with the expectation that the government would, in turn, support the creation of the necessary environment for cross-sectoral economic growth.



The Kingdom of Morocco

Dr. Mohamed TAAMOUTI

Head of Economics and International Relations Department

Bank Al-Maghrib

Abu Dhabi, United Arab Emirates



Summary

In recent years, the framework for the conduct of monetary policy in Morocco has been substantially overhauled to better adapt it to changes in the Moroccan economy in general and the financial system in particular.

In 2006, monetary policy saw a turning point with the adoption of the new statute of Bank Al-Maghrib (BAM), by which the maintenance of price stability has become one of the core missions of the central bank. The new statute has also given it more autonomy in the conduct of monetary policy. Since then, BAM has worked to strengthen monetary policy implementation framework to align it with best practices.

In 2013, under its three-year strategic plan 2013–2016, BAM set the strategic goal of adapting the framework for the conduct of monetary policy in preparation for the expected transition to a more flexible exchange rate regime and inflation targeting. Consequently, it started the development of a new forecasting and policy analysis system (FPAS) capable of supporting the planned transition. The latter consists of a central monetary policy model (MQPM40) that helps to produce medium-term forecasts and integrates a structural model (MOPAM41) for the simulation of medium and long-term impacts of public policies and structural reforms.

In 2016, this framework was rolled out, and a new forecasting process was put in place. The latter has helped to strengthen interaction within the forecasting team on the one hand and between the forecasting team and monetary policy governance bodies on the other hand. In particular, a new committee was set up to examine macroeconomic projections prior to submission to the Monetary and Financial Committee (MFC)42 and then to the Bank Board.

40 Moroccan Quarterly Projection Model. 41 Moroccan Policy Analysis Model. 42 The MFC is chaired by the Governor and is composed of the Director General and the heads of

departments involved in the preparation and conduct of monetary policy. The MFC meets monthly to review and validate analyzes and forecasts of economic, monetary and financial developments. For the preparation of the Committee’s meetings prior to the Bank Board meeting, a Pre-MFC Committee, chaired by the Director General, is held to discuss macroeconomic projections and validate the related alternative scenarios.


Summary

In recent years, the framework for the conduct of monetary policy in Morocco has been substantially overhauled to better adapt it to changes in the Moroccan economy in general and the financial system in particular.

In 2006, monetary policy saw a turning point with the adoption of the new statute of Bank Al-Maghrib (BAM), by which the maintenance of price stability has become one of the core missions of the central bank. The new statute has also given it more autonomy in the conduct of monetary policy. Since then, BAM has worked to strengthen monetary policy implementation framework to align it with best practices.

In 2013, under its three-year strategic plan 2013–2016, BAM set the strategic goal of adapting the framework for the conduct of monetary policy in preparation for the expected transition to a more flexible exchange rate regime and inflation targeting. Consequently, it started the development of a new forecasting and policy analysis system (FPAS) capable of supporting the planned transition. The latter consists of a central monetary policy model (MQPM40) that helps to produce medium-term forecasts and integrates a structural model (MOPAM41) for the simulation of medium and long-term impacts of public policies and structural reforms.

In 2016, this framework was rolled out, and a new forecasting process was put in place. The latter has helped to strengthen interaction within the forecasting team on the one hand and between the forecasting team and monetary policy governance bodies on the other hand. In particular, a new committee was set up to examine macroeconomic projections prior to submission to the Monetary and Financial Committee (MFC)42 and then to the Bank Board.

40 Moroccan Quarterly Projection Model. 41 Moroccan Policy Analysis Model. 42 The MFC is chaired by the Governor and is composed of the Director General and the heads of

departments involved in the preparation and conduct of monetary policy. The MFC meets monthly to review and validate analyzes and forecasts of economic, monetary and financial developments. For the preparation of the Committee’s meetings prior to the Bank Board meeting, a Pre-MFC Committee, chaired by the Director General, is held to discuss macroeconomic projections and validate the related alternative scenarios.


At the same time, communication on monetary policy has been adjusted as well, by reinforcing policy guidance and improving the transparency of the decision-making process. In this regard, the Monetary Policy Report has seen significant changes, including in particular the addition of a new chapter on macroeconomic forecasts. The press release issued after the Board meetings was also overhauled.

1. A changing economic and institutional environment

Over the last decade, the international economic environment has been marked by the severe financial crisis of 2008 as well as by the high volatility of commodity prices, especially oil.

In this context, although the Moroccan financial system has shown some resilience, the real economy has nevertheless been impacted through several channels, mainly foreign demand and remittances, particularly from the eurozone.

Source: Datastream and HCP43

43 National High Commission for Planning.

Chart (1): Moroccan Nonagricultural and Euro Area Growth

(%)


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At the same time, communication on monetary policy has been adjusted as well, by reinforcing policy guidance and improving the transparency of the decision-making process. In this regard, the Monetary Policy Report has seen significant changes, including in particular the addition of a new chapter on macroeconomic forecasts. The press release issued after the Board meetings was also overhauled.

1. A changing economic and institutional environment

Over the last decade, the international economic environment has been marked by the severe financial crisis of 2008 as well as by the high volatility of commodity prices, especially oil.

In this context, although the Moroccan financial system has shown some resilience, the real economy has nevertheless been impacted through several channels, mainly foreign demand and remittances, particularly from the eurozone.

Source: Datastream and HCP43

____________________ 43 National High Commission for Planning.

Chart (1): Moroccan Nonagricultural and Euro Area Growth


Thus, from 2013 the national economy started to slow down. Nonagricultural added value trended downward, hovering around 2 percent as against 4.8 percent on average between 2000 and 2008. Labor market conditions deteriorated somewhat, with a drop-in labor force participation rate and an increase in unemployment. In addition, the rise in oil prices since 2011 has led to the deterioration of macroeconomic balances, as fiscal and current account deficits in 2012 reached 7.2 percent and 9.5 percent of GDP, respectively. Foreign exchange reserves started to trend downward as from 2010, reaching 141.4 billion dirhams in 2012, the equivalent of 4 months of imports.

Source: Foreign Exchange Office and BAM.

Source: Ministry of Finance.

Chart 2: Current account deficit as % of GDP and net international reserves (NIR) in months of imports

Chart 3: Fiscal deficit as % of GDP


Thus, from 2013 the national economy started to slow down. Nonagricultural added value trended downward, hovering around 2 percent as against 4.8 percent on average between 2000 and 2008. Labor market conditions deteriorated somewhat, with a drop-in labor force participation rate and an increase in unemployment. In addition, the rise in oil prices since 2011 has led to the deterioration of macroeconomic balances, as fiscal and current account deficits in 2012 reached 7.2 percent and 9.5 percent of GDP, respectively. Foreign exchange reserves started to trend downward as from 2010, reaching 141.4 billion dirhams in 2012, the equivalent of 4 months of imports.

Source: Foreign Exchange Office and BAM.

Source: Ministry of Finance.

Chart 2: Current account deficit as % of GDP and net international reserves (NIR) in months of imports

Chart 3: Fiscal deficit as % of GDP


In response, the authorities initiated several structural reforms, the most important of which include – in terms of public finance – the gradual reform of the system of subsidizing petroleum products with the establishment in 2013 of a price indexing system and then total liberalization of the market from December 2015. Similarly, a new Bylaw on Finance Acts was enacted with the aim of strengthening the control and transparency of government spending and improving the visibility of budget execution by introducing result-oriented management and multiannual programming. A reform of pension schemes was also launched by adjusting certain parameters, mainly the retirement age, the basis and the rate of calculation. These efforts, combined with the drop in oil prices since 2014 and the good export performance of some of Morocco’s world crafts, have resulted in a gradual recovery of macroeconomic balances and created a fiscal space that enabled the authorities to strengthen social safety nets.

Moreover, in order to support its policy of economic openness, preserve the competitiveness of its economy, strengthen its resilience and improve its shock absorption capacity, Morocco has been preparing for some years now the transition to a more flexible exchange rate regime. This shift requires certain preconditions, including the control of macroeconomic balances, adequate foreign exchange reserves, and a sound banking sector. Today, these prerequisites are broadly fulfilled44 and Morocco will soon begin this transition on a gradual basis. The institutional environment of monetary policy in Morocco has also seen several developments. Drawing lessons from the international financial crisis and taking into account changes in the economy and the financial system, BAM has undertaken several reforms. In 2014, a new Banking Act was adopted, establishing – inter alia – the Systemic Risk Coordination and Monitoring Committee. Given the foreign expansion of Moroccan banks, particularly in sub-Saharan Africa, this Act also provides for the monitoring of cross-border risks, in particular by creating supervisory colleges and carrying out on-site inspections. It has also extended the scope of banking supervision to other financial institutions and tightened prudential regulation.

In addition, the new Banking Act introduces provisions on participatory banking. So far, the Credit Institutions Committee has licensed five participatory banks and authorized three existing banks to open participatory windows, in order to offer their customers alternative banking products.

44 Macroeconomic balances and foreign exchange reserves have improved significantly since 2013, and the Moroccan banking system was considered sound and resilient by the World Bank and IMF joint FSAP mission in April 2015.


BAM has also revamped its statute, which is currently in the process of being adopted. This overhaul aims at strengthening BAM’s autonomy in monetary policy, giving it in particular the power to define the objective of price stability and to conduct monetary policy independently. It also broadens central bank mandate to include financial stability and the contribution to financial inclusion and introduces a new legal framework for the management of systems and means of payment.

2. Adapting the strategic framework of monetary policy

The primary objective of monetary policy in Morocco is price stability, as stipulated in Article 6 of BAM’s current statute: “In order to ensure price stability, the Bank shall set and implement monetary policy instruments. To this end, the Bank shall intervene in the money market using appropriate instruments.”

In Morocco, price stability is captured by reference to a moderate change in the consumer price index (CPI). This index reflects the cost of a reference basket representing the consumption pattern of the average urban household. It is calculated based on a monthly survey covering 17 cities, 478 products, and 1067 varieties.

Monetary policy is conducted under a fixed exchange rate system and a capital account that is completely open for nonresidents and partially open for residents. Monetary policy enjoys, therefore, some degree of autonomy, due to the imperfect substitutability of domestic and foreign capital markets.

To achieve its objective of price stability, BAM uses two main instruments, the key rate and the required reserve ratio. The key rate is the interest rate of BAM’s seven-day advances to commercial banks and serves as a reference for all its operations with banks. BAM determines the key rate based on a forward-looking assessment of inflationary pressures and risks surrounding medium-term inflation forecasts.

The required reserve45 represents the share of liabilities that commercial banks are required to keep on their demand deposits with BAM. It allows a structural regulation of banks’ liquidity situation, which is one of the main determinants of credit supply.

45 The payment of interest on required reserves was abolished in December 2013. However, the Bank has recently decided to pay banks making above-average lending growth.


BAM has also revamped its statute, which is currently in the process of being adopted. This overhaul aims at strengthening BAM’s autonomy in monetary policy, giving it in particular the power to define the objective of price stability and to conduct monetary policy independently. It also broadens central bank mandate to include financial stability and the contribution to financial inclusion and introduces a new legal framework for the management of systems and means of payment.

2. Adapting the strategic framework of monetary policy

The primary objective of monetary policy in Morocco is price stability, as stipulated in Article 6 of BAM’s current statute: “In order to ensure price stability, the Bank shall set and implement monetary policy instruments. To this end, the Bank shall intervene in the money market using appropriate instruments.”

In Morocco, price stability is captured by reference to a moderate change in the consumer price index (CPI). This index reflects the cost of a reference basket representing the consumption pattern of the average urban household. It is calculated based on a monthly survey covering 17 cities, 478 products, and 1067 varieties.

Monetary policy is conducted under a fixed exchange rate system and a capital account that is completely open for nonresidents and partially open for residents. Monetary policy enjoys, therefore, some degree of autonomy, due to the imperfect substitutability of domestic and foreign capital markets.

To achieve its objective of price stability, BAM uses two main instruments, the key rate and the required reserve ratio. The key rate is the interest rate of BAM’s seven-day advances to commercial banks and serves as a reference for all its operations with banks. BAM determines the key rate based on a forward-looking assessment of inflationary pressures and risks surrounding medium-term inflation forecasts.

The required reserve45 represents the share of liabilities that commercial banks are required to keep on their demand deposits with BAM. It allows a structural regulation of banks’ liquidity situation, which is one of the main determinants of credit supply.

45 The payment of interest on required reserves was abolished in December 2013. However, the Bank has recently decided to pay banks making above-average lending growth.


These two instruments are managed by the Bank Board, the highest authority in charge of monetary policy governance. To define the monetary policy stance, the Board meets quarterly, based on an annual schedule published on the Bank’s website at the beginning of each year. Chaired by the Governor, the Board is composed of the Director General of the Bank, the Finance Ministry’s Director of Treasury and External Finance46, in addition to six members appointed by the Head of Government, including three on the proposal of the Governor, from persons known for their competence in the monetary, financial and economic fields and exercising no elective office and no position of responsibility in banking or financial institutions or in public administration.

In addition to these two tools, the Bank can use nonconventional instruments. By the same token, BAM has implemented, since December 2013, several measures47 with a view to further support the financing of very small, small and medium-sized enterprises (VSMEs), which were most hit by the troubled economic environment.

Monetary policy decisions in Morocco are mainly transmitted through credit and interest rate channels, while the exchange rate channel is inactive. Bank loans to the nonfinancial sector constitute a major source for financing the economy; its ratio to GDP reached 68.4 percent in 2016. Loans granted to companies represent 41 percent of outstanding loans to the nonfinancial sector, as against 26 percent for household loans, of which 71.6 percent are home loans. On the other hand, the debt market is dominated by government securities whose outstanding amount reached 48 percent of GDP in 2016, while private securities are issued mainly by large companies, with an outstanding amount of merely 6.4 percent of GDP. The contribution of the stock market to financing the economy is still weak.

To ensure the transmission of its decisions, the Bank has used, since 2006, the interbank weighted average rate, which represents a reference rate for other markets, as its operational target that it seeks to keep very close to the key rate through its interventions in the money market.

46 The Director of Treasury and External Finance does not take part in voting on monetary policy decisions.

47 These measures are developed in Section 5 on “Monetary policy decisions”.


Box 1: Transmission of monetary policy decisions in Morocco To assess the transmission of monetary policy decisions to the economy, simulation exercises were carried out using the MQPM model. They showed that a one-percentage-point increase of the key rate leads to a 0.7 percent rise in the effective interest rate1. The latter causes monetary conditions to tighten, which in turn drags down domestic demand, mainly consumption and investment, by about 0.15 percentage point, thus generating disinflationary pressures and bringing down inflation by 0.1 percentage point. At the same time, the real effective exchange rate depreciates due to lower inflation, therefore improving the competitiveness of national exports. These developments help inflation to adjust and return to its implicit target, defined as the target conditioned by the fixed exchange rate regime.

Similarly, a measure affecting the required reserve tightens monetary conditions and reduces credit supply. Simulations using a credit disequilibrium model show that a one-percentage-point upward shock on credit supply capacity, measured by the difference between deposits and the required reserve, triggers a 1.3 percent increase in credit supply. 1 See Section 3 below on the “New forecasting and policy analysis system (FPAS)”.

Chart B.1: Impulse responses generated by a 1-percent interest rate shock


Box 1: Transmission of monetary policy decisions in Morocco To assess the transmission of monetary policy decisions to the economy, simulation exercises were carried out using the MQPM model. They showed that a one-percentage-point increase of the key rate leads to a 0.7 percent rise in the effective interest rate1. The latter causes monetary conditions to tighten, which in turn drags down domestic demand, mainly consumption and investment, by about 0.15 percentage point, thus generating disinflationary pressures and bringing down inflation by 0.1 percentage point. At the same time, the real effective exchange rate depreciates due to lower inflation, therefore improving the competitiveness of national exports. These developments help inflation to adjust and return to its implicit target, defined as the target conditioned by the fixed exchange rate regime.

Similarly, a measure affecting the required reserve tightens monetary conditions and reduces credit supply. Simulations using a credit disequilibrium model show that a one-percentage-point upward shock on credit supply capacity, measured by the difference between deposits and the required reserve, triggers a 1.3 percent increase in credit supply. 1 See Section 3 below on the “New forecasting and policy analysis system (FPAS)”.

Chart B.1: Impulse responses generated by a 1-percent interest rate shock


3. New forecasting and policy analysis system (FPAS)

a. Analytical framework

A new analytical and forecasting framework was implemented in 2016. It rests on a large number of macroeconomic aggregates covering economic and monetary conditions both nationally and internationally, and is structured around three pillars:

Chart 4: Key Rate and Interbank rate

Chart 5: Analytical framework of monetary policy

Inflationary pressures

- Exchange rate - Interest rates - NIR - Credit - Bank liquidity - Assets market

Pillar 2: Monetary sphere

Foreign demand to Morocco, transfers and

producer costs

Exchange rate and interest

rates

Fiscal policy stance

- Growth - Labor - Commodity prices - Exchange rate - Interest rates - Inflation

Pillar 1: International environment

- Growth - Labor market (wages and

labor productivity) - Other producer costs

Pillar 3: Real sphere

Output gap

Monetary conditions

index

Public spending

Pressures on monetary conditions

Imported inflation

Producer costs

Treasury financing conditions

Interbank rate rate


133

3. New forecasting and policy analysis system (FPAS)

a. Analytical framework

A new analytical and forecasting framework was implemented in 2016. It rests on a large number of macroeconomic aggregates covering economic and monetary conditions both nationally and internationally, and is structured around three pillars:

Chart 4: Key Rate and Interbank rate

Chart 5: Analytical framework of monetary policy

Interbank rate Key rate


The first pillar helps to assess pressures on prices originating from the international environment. These can result directly from the change in commodity prices, especially energy products, and finished consumer products’ prices, and indirectly through foreign demand pressure on the supply of goods and services as well as the pressure of exchange rate trend on monetary conditions.

The second pillar focuses on the development of monetary conditions and its impact on growth. It is based on a number of variables, including interest rates in the different markets, the real effective exchange rate, bank credit, bank liquidity and asset prices in the real estate and financial markets. This analysis is supplemented by the results of BAM surveys on lending rates and lending conditions. The conclusions of these analyses are summarized in the Monetary Conditions Index, which is one of the determinants of aggregate demand.

The real pillar looks at aggregate demand with a focus on consumption, investment, net exports and government spending. The objective is to contextualize the economy in relation to its cycle and assess the level of the output gap, which represents one of the main indicators for measuring inflationary pressures. Similarly, the analysis of wages and commodity prices helps to evaluate changes in producer costs and their impact on prices in the medium run

The analytical framework of monetary policy in Morocco places a large emphasis on fiscal policy stance for two main reasons. Firstly, government spending, especially public investment, has a significant impact on economic activity. Secondly, sovereign bonds play an important role in the debt market, and changes in their rates affect interest rates on other markets.

Concerning inflation, which is a central variable of this framework, BAM analyzes its dynamics through four components: core inflation (CPIX), which reflects the underlying trend of prices and represents 67.1 percent of the consumer price index (CPI) basket; the prices of regulated products which account for nearly 18.4 percent of this basket; the prices of fuels and lubricants indexed on international prices; and volatile food prices. As major movements of inflation in Morocco are inextricably linked to developments in world inflation, particularly in the euro area, Morocco’s main trading partner, BAM closely monitors the prices of tradable goods, which account for 52 percent of the CPIX basket.


The first pillar helps to assess pressures on prices originating from the international environment. These can result directly from the change in commodity prices, especially energy products, and finished consumer products’ prices, and indirectly through foreign demand pressure on the supply of goods and services as well as the pressure of exchange rate trend on monetary conditions.

The second pillar focuses on the development of monetary conditions and its impact on growth. It is based on a number of variables, including interest rates in the different markets, the real effective exchange rate, bank credit, bank liquidity and asset prices in the real estate and financial markets. This analysis is supplemented by the results of BAM surveys on lending rates and lending conditions. The conclusions of these analyses are summarized in the Monetary Conditions Index, which is one of the determinants of aggregate demand.

The real pillar looks at aggregate demand with a focus on consumption, investment, net exports and government spending. The objective is to contextualize the economy in relation to its cycle and assess the level of the output gap, which represents one of the main indicators for measuring inflationary pressures. Similarly, the analysis of wages and commodity prices helps to evaluate changes in producer costs and their impact on prices in the medium run

The analytical framework of monetary policy in Morocco places a large emphasis on fiscal policy stance for two main reasons. Firstly, government spending, especially public investment, has a significant impact on economic activity. Secondly, sovereign bonds play an important role in the debt market, and changes in their rates affect interest rates on other markets.

Concerning inflation, which is a central variable of this framework, BAM analyzes its dynamics through four components: core inflation (CPIX), which reflects the underlying trend of prices and represents 67.1 percent of the consumer price index (CPI) basket; the prices of regulated products which account for nearly 18.4 percent of this basket; the prices of fuels and lubricants indexed on international prices; and volatile food prices. As major movements of inflation in Morocco are inextricably linked to developments in world inflation, particularly in the euro area, Morocco’s main trading partner, BAM closely monitors the prices of tradable goods, which account for 52 percent of the CPIX basket.


Chart 6: Inflation Dynamics analysis Diagram

Chart 8: Prices of tradables included in the CPIX and Inflation in the Euro Area

Chart 7: Inflation and Core Inflation


Given the role of anchoring inflation expectations in the transmission of monetary policy decisions, BAM has been conducting a quarterly survey on inflation expectations since 2012. This survey collects the views of economic operators, particularly in the financial sector, about their inflation expectations within horizons of 4, 8 and 12 quarters.

b. Forecasting system

Under the new FPAS, BAM has put in place a more comprehensive and integrated

forecasting system. This framework, which ensures a better coherence of

macroeconomic forecasts, is centered on the MQPM model (Figure 3) and consists of

several satellite models that provide it with short-term projections and produce

medium-term forecasts of aggregates not included in the MQPM.

Chart 9: Inflation Expectations (%)


Given the role of anchoring inflation expectations in the transmission of monetary policy decisions, BAM has been conducting a quarterly survey on inflation expectations since 2012. This survey collects the views of economic operators, particularly in the financial sector, about their inflation expectations within horizons of 4, 8 and 12 quarters.

b. Forecasting system

Under the new FPAS, BAM has put in place a more comprehensive and integrated

forecasting system. This framework, which ensures a better coherence of

macroeconomic forecasts, is centered on the MQPM model (Figure 3) and consists of

several satellite models that provide it with short-term projections and produce

medium-term forecasts of aggregates not included in the MQPM.

Chart 9: Inflation Expectations (%)


The MQPM is a semi-structural business cycle model that ensures both the theoretical coherence of structural models (stochastic dynamic general equilibrium models) and the empirical adjustment to data as provided by econometric models. It is a flexible model that produces forecasts in several stages and is interactive as it integrates the judgments of sector experts. It is composed of four interconnected blocks: 1) monetary policy; 2) aggregated demand; 3) aggregate supply; and 4) the external sector.

The monetary policy block takes into account the fixed nature of the exchange rate regime where the nominal value of the dirham is determined in relation to a basket of currencies made up of the euro and the U.S. dollar, whose respective weights are 60 percent and 40 percent. It also takes into account the restricted capital mobility for residents, which gives monetary policy some independence in setting interest rates. This hybrid situation is taken into consideration through the effective interest rate, defined as a weighted average of the key rate and the implicit interest rate that would exclude arbitrage opportunities in the context of total capital mobility.

Chart 10: Architecture of the forecasting system


138

The second block model growth from a demand perspective in order to capture inflationary pressures according to their origin and the transmission of monetary policy decisions to the real economy. Household final consumption is determined by overall income, remittances and the real effective interest rate which determines the effect of inter-temporal substitution. Investment is determined primarily by expectations of the economic cycle, agricultural output and the real value of capital48, while general government consumption is considered exogenous. Exports are determined by the level of economic activity in partner countries and the real effective exchange rate, while imports are particularly set by the imported content of each component of demand.

The supply block describes the pricing process by distinguishing four subcomponents. Core inflation is determined by a hybrid Phillips curve where marginal costs are determined by the demand cycle and the exchange rate. Fuel prices are linked to international oil prices, while regulated prices are considered exogenous, and prices of volatile food products are assumed to follow a low-persistence autoregressive process.

The external block, which captures the trend in the international economic situation, is completely exogenous and receives input from the GPM model developed and sustained by the Global Projection Model Network (GPMN49) of which BAM is a member. It provides the MQPM with the entire international economic outlook (growth and inflation in partner and competitor countries, commodity prices, exchange rates and interest rates).

The MQPM is supplemented by a variety of satellite models in order to produce the initial conditions and medium-term projections for the aggregates that are not included in the MQPM, notably agricultural output, public finance, current account, international reserves and bank lending. To ensure the overall consistency of the projections, sectoral experts rely on medium-term forecasts (growth, inflation, interest rates and exchange rates) delivered by the MQPM as inputs in their econometric models.

The rollout of the FPAS in 2016 was accompanied by the implementation of a new forecasting process that strengthened interaction within the projection team as well as with monetary policy governance bodies. This process takes place in three phases, spanning 4 weeks: ____________________ 48 The real value of capital is assessed by a function of the expected future consumption and the real

interest rate. 49 GPMN is a non-profit research institute that regularly provides global macroeconomic forecasts and

risk scenarios. It uses the IMF’s Global Projection Model (GPM) as the main tool in its forecasting kit, with additional contributions from other more structural models.


The first phase is about setting the initial conditions, preparing short-term forecasts using the satellite models and the different qualitative information available, and reviewing the international environment forecasts provided by the GPMN.

The second phase begins after the approval meeting of the initial conditions and the evaluation of their consistency using the MQPM. This step consists in producing medium-term projections for 4 main variables, namely growth, inflation, interest rate and exchange rate. Once approved, the projections for these aggregates are used to produce forecasts for a number of variables not included in the MQPM.

During the third phase, forecasts are approved by the governance bodies of monetary policy. A pre-MFC meeting is held in order to analyze the forecasts and risks surrounding them and identify alternative scenarios. Subsequently, the forecasts and the results of the alternative scenarios are reviewed by the MFC members. After validation, they are submitted to the Board and then published in the Monetary Policy Report (MPR).

As part of revamping its forecasting and analysis system, BAM has also developed the Moroccan Policy Analysis Model (MOPAM) which allows simulating medium and long-term impact of public policies and structural and fiscal reforms. The simulation results serve to refine and update the calibration of the MQPM.

The MOPAM is a DSGE model in an open economy. It is composed of four main blocks: aggregate demand (households, government and rest of the world), aggregate supply (capital, labor and total factor productivity), prices (core inflation, energy prices and food prices) and economic policies (monetary policy and fiscal policy).

Chart 11: Timetable for the Development of macroeconomic forecasts


4. More transparent and forward-looking communication

In 2006, BAM developed a new communication framework for monetary policy close to practice in central banks adopting inflation targeting. At the end of the Board’s quarterly meeting, the Bank publishes a press release in which it announces the decision and summarizes the rationale behind it, and the Governor holds a press conference. A detailed report (MPR) presenting an assessment of the economic and financial situation and medium-term inflation forecasts is published on the same day.

In addition, the Bank organizes regular meetings with the banking system and business representatives in order to explain monetary policy decisions and facilitate their transmission.

In 2016, with the implementation of the new FPAS, BAM adapted its communication system, advocating a more forward-looking approach and more transparency. The MPR has undergone several changes to better reflect the new analytical and forecasting framework. Besides the layout and the introduction of several indicators for a more profound analysis, the main improvement lies in the addition of a new chapter devoted to macroeconomic outlook. This chapter presents the forecasts of several important variables, including inflation, growth, current account, fiscal deficit, net international reserves, bank lending and bank liquidity. For the sake of transparency, revisions made to projections and

Chart 12: MOPAM Architecture


4. More transparent and forward-looking communication

In 2006, BAM developed a new communication framework for monetary policy close to practice in central banks adopting inflation targeting. At the end of the Board’s quarterly meeting, the Bank publishes a press release in which it announces the decision and summarizes the rationale behind it, and the Governor holds a press conference. A detailed report (MPR) presenting an assessment of the economic and financial situation and medium-term inflation forecasts is published on the same day.

In addition, the Bank organizes regular meetings with the banking system and business representatives in order to explain monetary policy decisions and facilitate their transmission.

In 2016, with the implementation of the new FPAS, BAM adapted its communication system, advocating a more forward-looking approach and more transparency. The MPR has undergone several changes to better reflect the new analytical and forecasting framework. Besides the layout and the introduction of several indicators for a more profound analysis, the main improvement lies in the addition of a new chapter devoted to macroeconomic outlook. This chapter presents the forecasts of several important variables, including inflation, growth, current account, fiscal deficit, net international reserves, bank lending and bank liquidity. For the sake of transparency, revisions made to projections and

Chart 12: MOPAM Architecture


deviations from actual rates are presented and explained. “Fiscal policy stance” and “External accounts” have been established as separate chapters because of the importance of analyzing them for monetary policy purposes.

In the same context, the press release of the Board meeting has undergone significant changes, reducing its quantitative content and putting more focus on policy guidance. Its layout was reshuffled to put the Board’s decision at the beginning, followed by an explicit presentation of its foundations, in particular recent and future trend in inflation and the international and national economic developments.

The Bank has also undertaken other actions to ensure wide dissemination and good understanding of its decisions, including:

i. The online and live streaming of the Governor’s press conference on the Bank’s YouTube channel and Twitter account;

ii. The organization of training sessions for specialized journalists; iii. The posting of several educational videos and other communication tools

relating to monetary policy on the Bank’s website, the objective being to explain to the general public the Bank’s missions as well as some ongoing projects, in particular the transition to a more flexible exchange rate regime;

iv. The redesign of the Bank’s website, notably improving its ergonomics.

5. Monetary policy decisions

As of 2013, nonagricultural growth in Morocco slowed down, mostly because of the persistently sluggish activity in the euro area, notably in our main partners. More recently, and with the improvement of growth in the euro area, economic activity in Morocco is recovering, albeit at a still slow pace.

In terms of macroeconomic balances, twin deficits reached high levels in 2011 and 2012, exacerbated by continued rise in energy prices. From 2014, with the downward trend in oil prices and the reform of the system of subsidies for oil products, current account and fiscal deficits have gradually eased to return to sustainable levels.

In this context, and considering that inflation rates were broadly in line with the objective of price stability, BAM adopted an accommodative monetary policy to support economic growth.


142

Indeed, the Bank lowered the key rate three times between 2014 and 2016 to 2.25 percent, while keeping the required reserve ratio at a low level. In addition, BAM took unconventional measures in favor of VSMEs. Furthermore, after extending the scope of eligible collateral for monetary policy operations to securities representing receivables from VSMEs in 2012, the Bank put in place a program allowing banks to benefit from one-year advances, equivalent to the amounts they intend to grant to VSMEs, excluding enterprises operating in the property development sector and independent professions. Moreover, banks may obtain additional refinancing equivalent to the volume of loans granted to industrial or export-oriented VSMEs.

These various measures have helped to ease monetary conditions and led to a decline in lending rates50, whose average fell from 6.2 percent at end-2010 to 5.26 percent in the second quarter of 2017, as well as in interest rates in the different markets.

____________________ 50 Lending rates are obtained from a survey conducted quarterly by BAM among commercial banks. This

survey provides information on the various lending rates charged to the different institutional sectors as well as on their production.

Chart 13: Economic Growth

0

1

2

3

4

5

6

7

8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

%

Overall growth Nonagricultural growth


142

Indeed, the Bank lowered the key rate three times between 2014 and 2016 to 2.25 percent, while keeping the required reserve ratio at a low level. In addition, BAM took unconventional measures in favor of VSMEs. Furthermore, after extending the scope of eligible collateral for monetary policy operations to securities representing receivables from VSMEs in 2012, the Bank put in place a program allowing banks to benefit from one-year advances, equivalent to the amounts they intend to grant to VSMEs, excluding enterprises operating in the property development sector and independent professions. Moreover, banks may obtain additional refinancing equivalent to the volume of loans granted to industrial or export-oriented VSMEs.

These various measures have helped to ease monetary conditions and led to a decline in lending rates50, whose average fell from 6.2 percent at end-2010 to 5.26 percent in the second quarter of 2017, as well as in interest rates in the different markets.

____________________ 50 Lending rates are obtained from a survey conducted quarterly by BAM among commercial banks. This

survey provides information on the various lending rates charged to the different institutional sectors as well as on their production.

Chart 13: Economic Growth

0

1

2

3

4

5

6

7

8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

%

Overall growth Nonagricultural growth


However, albeit slightly improving, bank lending continued to grow at a relatively slow pace, despite the easing of supply conditions as reflected in Bank Al-Maghrib’s quarterly survey. According to the same survey, demand for credit remained weak, reflecting sluggish nonagricultural activities and the lack of visibility of economic operators amid a difficult international environment.

4

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Key rate Lending rates

Chart 14: Lending Rates and the Key Rate

Chart 15: Treasury Bond Yield Curve

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3 months 6 months 1 year 2 years 5 years 10 years 15 years 20 years

2009 2015 2016


The Bank has consequently adjusted its method of intervention on the money market by adopting a new rule for the distribution of seven-day advances, the objective being to favor the refinancing of banks that are most dynamic in the credit market and that best pass on monetary policy decisions to the rates they charge to their customers.

In response to the persistently weak growth in bank lending, BAM drew up a memorandum with business representatives and the banking system in order to develop concrete measures to boost credit. The memorandum proposes a set of measures for stakeholders to adopt and issues recommendations for the Government.

6. Challenges and Outlook

The efforts made by the authorities in recent years have helped to significantly improve macroeconomic balances and stir economic momentum, including a gradual acceleration of activity in the nonagricultural sectors. To maintain and strengthen this trend, it is necessary to carry on with the structural reforms to provide favorable conditions for a strong and sustainable growth.

In particular, the reform of the exchange rate regime should strengthen the capacity of the national economy to absorb external shocks, support its competitiveness, and serve as a lever for other macroeconomic policies.

Chart 16: Lending to the Nonfinancial Sector (Year -on- Year Change in %)

-5

0

5

10

15

20

25

30

Janu

ary

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juin

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nov.

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The Bank has consequently adjusted its method of intervention on the money market by adopting a new rule for the distribution of seven-day advances, the objective being to favor the refinancing of banks that are most dynamic in the credit market and that best pass on monetary policy decisions to the rates they charge to their customers.

In response to the persistently weak growth in bank lending, BAM drew up a memorandum with business representatives and the banking system in order to develop concrete measures to boost credit. The memorandum proposes a set of measures for stakeholders to adopt and issues recommendations for the Government.

6. Challenges and Outlook

The efforts made by the authorities in recent years have helped to significantly improve macroeconomic balances and stir economic momentum, including a gradual acceleration of activity in the nonagricultural sectors. To maintain and strengthen this trend, it is necessary to carry on with the structural reforms to provide favorable conditions for a strong and sustainable growth.

In particular, the reform of the exchange rate regime should strengthen the capacity of the national economy to absorb external shocks, support its competitiveness, and serve as a lever for other macroeconomic policies.

Chart 16: Lending to the Nonfinancial Sector (Year -on- Year Change in %)

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10

15

20

25

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Janu

ary

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juin

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17


This gradual transition would eventually increase the independence of monetary policy and allow, once the regime is flexible enough, the adoption of an inflation targeting framework. The latter is expected to improve the transmission of monetary policy decisions and enhance its effectiveness, through a better anchoring of inflation expectations by economic units. For the central bank, this represents a major challenge for which preparations have been under way for many years now.

Today, in view of its new statute which grants it a large degree of independence, the adjustment of its decision-support systems, the efforts initiated for almost a year to raise awareness and prepare economic units for this transition with in particular the development and implementation of an adapted communication strategy, the Bank would stir this transition under favorable conditions.

This reform and the ongoing digital revolution are among the most important factors that will shape the Moroccan financial landscape in the coming years. It is already experiencing deep-seated changes, notably with the recent entry into activity of participatory banks, the planned introduction of payment institutions, the development and implementation of a national strategy for financial inclusion, and the African expansion of Moroccan banks and insurance companies.



The Islamic Republic of Mauritania

Mr. Mohamed Salem Hemedy

Senior in the department of Monetary Policy & Exchange rate Policy

Central Bank of Mauritania



Mauritania’s Monetary Policy: Operational Framework

Introduction

Monetary policy is a set of means used by a country’s monetary authority to influence economic activity by regulating its currency. In Mauritania, monetary policy is conducted by the Central Bank of Mauritania, whose main objective is price stability, as set out in Article 38 of its Statute. To achieve the final objective of its monetary policy, the Central Bank of Mauritania also sets intermediate objectives, namely, the money supply. In order to achieve the intermediate objectives, it acts on a daily basis on operational objectives, namely the monetary base and bank liquidity.

Monetary policy action and the manipulation of monetary aggregates require a dynamic operational framework with active bodies and sufficient instruments to enable it to play its full role, which is not currently the case in Mauritania.

To make monetary policy more dynamic and to strengthen the operational framework, a new operational framework project developed by the Direction of the Monetary Policy (at the Central Bank) is in the process of validation by the Monetary Policy Council.

The purpose of this document is to provide a diagnosis of the operational framework for monetary policy in Mauritania and its improvement prospects through the new project of monetary policy operational framework.

I. Objectives of Monetary Policy in Mauritania

Article 38 of Ordinance 004/2007 on the Statute of the Central Bank defines the safeguarding price stability and combating inflation as the final objective of the monetary policy.

Because the central bank does not have the instruments to act directly on this final objective, it has used intermediate objectives with a stable link to the final objective. To this end, the central bank set intermediate targets, to ensure the stability of foreign exchange transactions and to control the growth of the money supply.

In order to achieve these intermediate and final objectives, the central bank acts on a daily basis on operational objectives which are more sensitive to instruments than intermediate objectives. These can be interbank market rates and bank reserves.


Mauritania’s Monetary Policy: Operational Framework

Introduction

Monetary policy is a set of means used by a country’s monetary authority to influence economic activity by regulating its currency. In Mauritania, monetary policy is conducted by the Central Bank of Mauritania, whose main objective is price stability, as set out in Article 38 of its Statute. To achieve the final objective of its monetary policy, the Central Bank of Mauritania also sets intermediate objectives, namely, the money supply. In order to achieve the intermediate objectives, it acts on a daily basis on operational objectives, namely the monetary base and bank liquidity.

Monetary policy action and the manipulation of monetary aggregates require a dynamic operational framework with active bodies and sufficient instruments to enable it to play its full role, which is not currently the case in Mauritania.

To make monetary policy more dynamic and to strengthen the operational framework, a new operational framework project developed by the Direction of the Monetary Policy (at the Central Bank) is in the process of validation by the Monetary Policy Council.

The purpose of this document is to provide a diagnosis of the operational framework for monetary policy in Mauritania and its improvement prospects through the new project of monetary policy operational framework.

I. Objectives of Monetary Policy in Mauritania

Article 38 of Ordinance 004/2007 on the Statute of the Central Bank defines the safeguarding price stability and combating inflation as the final objective of the monetary policy.

Because the central bank does not have the instruments to act directly on this final objective, it has used intermediate objectives with a stable link to the final objective. To this end, the central bank set intermediate targets, to ensure the stability of foreign exchange transactions and to control the growth of the money supply.

In order to achieve these intermediate and final objectives, the central bank acts on a daily basis on operational objectives which are more sensitive to instruments than intermediate objectives. These can be interbank market rates and bank reserves.


II. Monetary policy instruments.

There is a range of instruments at the disposal to the monetary authority to regulate the level of liquidity of the economy in accordance with the objective of price stability set in the context of stabilization policy. The instruments currently used by the central bank in the implementation of its monetary policy are the reserve requirement, the key interest rate, and the Treasury bill auctions.

II.1 The reserve requirement: According to this monetary policy instrument,

credit institutions are obliged to place a certain percentage of their deposits with the central bank. It is an instrument to enhance the effectiveness of interest rate policy. It is used to create or accentuate a liquidity deficit at the bank level, in order to strengthen the ability of central banks to intervene effectively as liquidity providers. As such, this instrument makes it possible to refine the management of interest rates on the money market. The reserve requirement is set at 7% on deposits from banks’ customers and is not remunerated. The duration of its constitution period is two weeks. The overdraft on reserves is presently subject to a penalty of 17% (delivered repo rate plus 8%).

Chart (1): Evolution of Banks Reserves

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70.00 Banks ReserveFree ReserveReserve Required


Table (1): Evolution of the reserve requirement rate

Date Jul. 1999 Sept. 2004 Jan. 2006 Sept. 2017

Rate 4.5% 8% 7% 7% Source: CBM

II.2. Treasury bill auctions: The Treasury bill market was launched in 1994 with a dual objective. First, to finance the budget deficit in the internal market on more competitive terms and to encourage better management of the State Treasury and public debt by making less use of direct financing by the Central Bank. Second, to serve on a transitional basis as a monetary policy instrument that will help to dry out excess liquidity waiting for the operationalization of the open market instrument. Treasury bill auctions are held weekly for maturities of (4, 13, 26, and 52 weeks). The interest rate set in the context of Treasury bill auctions can be assimilated to a floor policy rate.

In 2012, a seven-day Treasury bill (TB) maturity was introduced. It is used solely for monetary policy and liquidity management purposes. The issuance of seven-day Treasury bills is only available to institutions subject to minimum reserve requirements. The relative financial cost of this instrument is covered by the Treasury. A convention to this effect is signed between the Central Bank and the Minister of Finance.

II.3. The Policy interest rate: The policy interest rate or repo rate delivered against treasury bills is the rate at which banks can refinance themselves with the issuing institution. As such, it constitutes a ceiling rate for money market operations. It is currently set at 9%. The delivered repo can be done for maturities of 1 to 7 days. This operation is carried out at the initiative of the banks. However, the Central Bank may refuse to accept such a transaction if it considers that the banking system as a whole does not suffer from a liquidity shortage.

By setting the key rate at a given level, the Central Bank sends a signal on the orientation of the monetary policy. A rise in the key interest rate means a tightening of the key rate by an increase in the cost of money and credit. A downward trend in the key interest rate leads to a decline in the money market and credit rates.


Table (1): Evolution of the reserve requirement rate

Date Jul. 1999 Sept. 2004 Jan. 2006 Sept. 2017

Rate 4.5% 8% 7% 7% Source: CBM

II.2. Treasury bill auctions: The Treasury bill market was launched in 1994 with a dual objective. First, to finance the budget deficit in the internal market on more competitive terms and to encourage better management of the State Treasury and public debt by making less use of direct financing by the Central Bank. Second, to serve on a transitional basis as a monetary policy instrument that will help to dry out excess liquidity waiting for the operationalization of the open market instrument. Treasury bill auctions are held weekly for maturities of (4, 13, 26, and 52 weeks). The interest rate set in the context of Treasury bill auctions can be assimilated to a floor policy rate.

In 2012, a seven-day Treasury bill (TB) maturity was introduced. It is used solely for monetary policy and liquidity management purposes. The issuance of seven-day Treasury bills is only available to institutions subject to minimum reserve requirements. The relative financial cost of this instrument is covered by the Treasury. A convention to this effect is signed between the Central Bank and the Minister of Finance.

II.3. The Policy interest rate: The policy interest rate or repo rate delivered against treasury bills is the rate at which banks can refinance themselves with the issuing institution. As such, it constitutes a ceiling rate for money market operations. It is currently set at 9%. The delivered repo can be done for maturities of 1 to 7 days. This operation is carried out at the initiative of the banks. However, the Central Bank may refuse to accept such a transaction if it considers that the banking system as a whole does not suffer from a liquidity shortage.

By setting the key rate at a given level, the Central Bank sends a signal on the orientation of the monetary policy. A rise in the key interest rate means a tightening of the key rate by an increase in the cost of money and credit. A downward trend in the key interest rate leads to a decline in the money market and credit rates.


Table (2): Evolution of the CBM (Central Bank) policy Rate

Date Oct. 01 Feb. 05 Oct. 05 2007 2009 Sept. 2017

RATE 11% 13% 14% 12% 9% 9%

III. Monetary Policy Decision-Making Body

At this time, there is a separation between the responsibilities of conducting monetary policy (Monetary Policy Council) and those related to the day-to-day management of the Central Bank (General Council). This is reflected in the implementation of separate and independent decision-making processes. In accordance with the BCM’s Statutes, the Monetary Policy Council is the decision-making body primarily responsible for defining monetary policy. It meets monthly and its agenda is adopted by the Governor who chairs it. In addition to the Monetary Policy Council, there is a Monetary and Budgetary Policy Committee (CPMB) which is a technical framework for exchange, coordination, and consultation for the implementation of monetary and budgetary policies. Some of the Committee’s prerogatives are against central bank independence. There is also an Investment Committee in charge of reserves management and a BCM Bonds Auction Committee in charge of the counting the offers when the BCM Bonds are issued. However, there is neither a strategic nor an operational body in the monetary policy decision-making process.

0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%16.00%

Policy rate

Chart (2): Evolution of CBM Policy Rate


IV. Monetary Policy and Exchange rate Regime.

With the creation of the foreign exchange market in 2007, the BCM continues to operate a floating exchange rate regime. In practice, the exchange rate regime can be assimilated to a sliding anchor against the dollar. The crawl rate was strongly influenced by the evolution of the EUR/USD, with the aim of limiting the impact of EUR / USD variability on the bilateral exchange rates of the ouguiya.

With regard to the relationship with monetary policy, following the historical evolution of demand on the exchange market and bank liquidity shows that banks prefer to invest their liquidity in foreign trade. As a result, any surplus of free reserve held by the banks has an impact on currency demand and puts pressure on the central bank’s currency reserves, which are forced to intervene in order to guarantee the stability of the exchange rate. The following chart shows the evolution of demand on the exchange market and the free reserves of banks.

Chart (3): Exchange Rate Evolution


IV. Monetary Policy and Exchange rate Regime.

With the creation of the foreign exchange market in 2007, the BCM continues to operate a floating exchange rate regime. In practice, the exchange rate regime can be assimilated to a sliding anchor against the dollar. The crawl rate was strongly influenced by the evolution of the EUR/USD, with the aim of limiting the impact of EUR / USD variability on the bilateral exchange rates of the ouguiya.

With regard to the relationship with monetary policy, following the historical evolution of demand on the exchange market and bank liquidity shows that banks prefer to invest their liquidity in foreign trade. As a result, any surplus of free reserve held by the banks has an impact on currency demand and puts pressure on the central bank’s currency reserves, which are forced to intervene in order to guarantee the stability of the exchange rate. The following chart shows the evolution of demand on the exchange market and the free reserves of banks.

Chart (3): Exchange Rate Evolution


V. Monetary Policy and Fiscal Policy

Fiscal policy is geared towards strengthening the stability of the macroeconomic framework by supporting growth, promoting employment and improving people’s living conditions. It is managed by the Ministry of Finance.

In order to meet its short-term needs, the Treasury uses the Treasury bond market, which is currently managed by the Central Bank in close coordination with the Treasury. This market has now become the main money market compartment due to the low transaction volumes of the interbank market and the absence of weekly central bank operations, and its TB rate has become the reference rate of the money market. The following chart shows the evolution of banking and non-bank TB outstandings.

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Free Reserve

Linear (Demand FOREX)

Linear (Free Reserve)

Chart (4): Free Reserves and Foreign Exchange Market Demand (2014 – 2016)

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100.00TB Non-BankingTB Banking

Chart (5): Evolution of TB Outstanding


With regard to bank liquidity, government operations through the expenditures and revenues of the public treasury constitute the main autonomous factor influencing this liquidity, hence the importance of monitoring changes in the treasury balance.

VI. Prospects for Improvement

The lack of dynamism in the current framework and the insufficiency of monetary policy instruments have led to inactive and segmented interbank market with a limited number of participants and concentrated liquidity at the level of some banks. To address this situation and to make monetary policy more dynamic, the central bank of Mauritania has set up a new operational framework enabling it to have an organizational framework and a set of instruments in line with international standards that will ensure the efficient management of banking liquidity.

Chart (6): Evolution of the weighted average TB rate

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10.00%

TB Rate

Chart (7): Free Reserves and Treasury Cash Balance

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10.00 15.00 20.00 25.00 30.00 35.00 40.00

Treasury cashFree ReserveLinear (Treasury cash)Linear (Free Reserve)


With regard to bank liquidity, government operations through the expenditures and revenues of the public treasury constitute the main autonomous factor influencing this liquidity, hence the importance of monitoring changes in the treasury balance.

VI. Prospects for Improvement

The lack of dynamism in the current framework and the insufficiency of monetary policy instruments have led to inactive and segmented interbank market with a limited number of participants and concentrated liquidity at the level of some banks. To address this situation and to make monetary policy more dynamic, the central bank of Mauritania has set up a new operational framework enabling it to have an organizational framework and a set of instruments in line with international standards that will ensure the efficient management of banking liquidity.

Chart (6): Evolution of the weighted average TB rate

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10.00%

TB Rate

Chart (7): Free Reserves and Treasury Cash Balance

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Treasury cashFree ReserveLinear (Treasury cash)Linear (Free Reserve)


155

VI.1. Monetary Policy Instruments The new operational framework that is currently being validated proposes a set of instruments that are recognized and used in most central banks:

The main operations: which are intended to provide or withdraw liquidity on a regular basis, with a weekly frequency over a one-week maturity. They constitute the main instruments for implementing monetary policy.

Fine-tuning operations: are designed to mitigate the impact of unexpected fluctuations in liquidity. They are executed on an ad-hoc basis for less than seven days.

Standing facilities: which are intended to provide or withdraw liquidities on a day-to-day basis.

Long-term operations: which aim to inject or withdraw additional liquidities for a period longer than seven days.

Structural operations: are intended to manage a situation of surplus or insufficient liquidity of a lasting nature.

Required reserve: The new framework proposes to introduce a new reserve requirement rule based on the average observed during a reserve period (one month or four weeks). This will allow greater flexibility in banks’ cash flow and also a less reliance on the BCM.

The key rate: represents the reference rate for monetary policy operations. It shall be set by the instructions of the Governor of the Central Bank at a level compatible with the final objective of price stability.

VI.2. Monetary Policy Decision-Making Body In order to cope with the challenges of the current decision-making framework and to comply with international standards, the new framework proposes a new organization of decision-making bodies whose main characteristics are:

The creation of a strategic body in the form of a technical monetary policy committee whose main tasks are: the preparation of the monetary policy reports regular basis to support monetary policy decisions, the implementation of the Monetary Policy Council’s decisions, then the monitoring and the evaluation of monetary policy decisions.

The creation of an operational body in the form of money market committee in charge of the weekly management of banking liquidity.

Dedicate the existing Monetary and Budgetary Policy Committee to the coordination of forecasting teams and not to decision-making.


Conclusion

In Mauritania, monetary policy is a component of overall economic policy, and its main objective is price stability. This task of conducting monetary policy is assigned to the central bank, which has exercised it effectively since its creation; but in recent years, monetary policy has lost its effectiveness in favor of exchange rate stability, and the key interest rate has lost its influence.

Right now, and in order to increase the efficiency of the monetary policy, more efficient and dynamic, structural and organizational changes are taking place, namely the new draft operational framework currently being validated by the Monetary Policy Council, which proposes, on the one hand, a set of instruments enabling the central bank to manage the country’s money market, and, on the other hand, establishing of monetary policy decision-making bodies to facilitate the exchange rate and monetary policy actions.

Chart (8): Decision-Making and Implementation of Monetary Policy


Conclusion

In Mauritania, monetary policy is a component of overall economic policy, and its main objective is price stability. This task of conducting monetary policy is assigned to the central bank, which has exercised it effectively since its creation; but in recent years, monetary policy has lost its effectiveness in favor of exchange rate stability, and the key interest rate has lost its influence.

Right now, and in order to increase the efficiency of the monetary policy, more efficient and dynamic, structural and organizational changes are taking place, namely the new draft operational framework currently being validated by the Monetary Policy Council, which proposes, on the one hand, a set of instruments enabling the central bank to manage the country’s money market, and, on the other hand, establishing of monetary policy decision-making bodies to facilitate the exchange rate and monetary policy actions.

Chart (8): Decision-Making and Implementation of Monetary Policy



The European Central Bank

Mr. Frank Moss

Director General International and European Relations

European Central Bank



The euro area economy and the ECB’s monetary policy measures

Overview

• Economic activity in the euro area. • The ECB’s monetary policy measures. • The pass-through of the measures to the economy.

Short-term Outlook

Labour Market Tightness

Chart 1: Real GDP, composite PMI and ESI (index, lhs; quarterly percentage changes, rhs)

Sources: Markit, European Commission, Eurostat, MPE. Note: ESI is rescaled using the PMI historical mean and standard deviation. Latest observation: 2017Q2 (GDP), September 2017 (ESI), October (PMI), 2017Q3/Q4 (September 2017 MPE).

Chart 2: GDP composition (annual percentage changes, percentage points)

Sources: Eurostat, ECB calculations. Latest observations: 2017Q2.

Chart 3: Unemployment rate, level of employment and total hours worked

(lhs: index, rhs: percentage points)

Chart 4: Decomposition of wage developments and outlook

(annual percentage changes, quarterly data)

Sources: Eurostat, ECB calculations. Latest observations: 2017Q1 (employment, hours worked), 2017Q2 (unemployment).

Sources: Eurostat, ECB calculations. Note: The diamonds refer to the September 2017 MPE. Latest observations: 2017Q2 (release on 13 September included 2017Q2 data and revised previous quarters).


The euro area economy and the ECB’s monetary policy measures

Overview

• Economic activity in the euro area. • The ECB’s monetary policy measures. • The pass-through of the measures to the economy.

Short-term Outlook

Labour Market Tightness

Chart 1: Real GDP, composite PMI and ESI (index, lhs; quarterly percentage changes, rhs)

Sources: Markit, European Commission, Eurostat, MPE. Note: ESI is rescaled using the PMI historical mean and standard deviation. Latest observation: 2017Q2 (GDP), September 2017 (ESI), October (PMI), 2017Q3/Q4 (September 2017 MPE).

Chart 2: GDP composition (annual percentage changes, percentage points)

Sources: Eurostat, ECB calculations. Latest observations: 2017Q2.

Chart 3: Unemployment rate, level of employment and total hours worked

(lhs: index, rhs: percentage points)

Chart 4: Decomposition of wage developments and outlook

(annual percentage changes, quarterly data)

Sources: Eurostat, ECB calculations. Latest observations: 2017Q1 (employment, hours worked), 2017Q2 (unemployment).

Sources: Eurostat, ECB calculations. Note: The diamonds refer to the September 2017 MPE. Latest observations: 2017Q2 (release on 13 September included 2017Q2 data and revised previous quarters).


Recent Developments in Underlying Inflation

The ECB’s Monetary Policy Conventional and Unconventional Monetary Policy

Overall strategy

• Reductions in main policy rates counteract downside risks to price stability. • Non-standard measures complement/substitute reductions in main policy rate

in the presence of : ✓ Impairments in monetary policy transmission mechanism. ✓ Limited room for further interest rate reductions (close to lower bound).

Chart 5: HICP and HICP excluding food and energy

(annual percentage changes)

Chart 6: Measures of underlying inflation


Source: Eurostat. Latest observation: September 2017.

Sources: Eurostat, ECB calculations. Latest observations: September 2017. Note: The dynamic factor model (U2 Core) is based on the full 93 HICP items from each of 12 countries. Super-core is based only on those items in HICP excluding food and energy for which the output gap helps forecasting performance. The light blue range includes exclusion-based measures, trimmed means and a weighted median.


The ECB’s Non-standard Monetary Policy Measures

ECB Monetary Policy Measures Since June 2014

• Policy interest rates at or below 0: ✓ Deposit facility rate lowered in four steps from 0% to –0.4%.

• Credit operations ✓ Targeted longer-term refinancing operations (TLTRO 1 and 2), linked to

bank loans to non-financial corporations and households.

• Asset purchase programmes ✓ Purchases of private sector securities (ABS, covered bonds, corporate

securities) ✓ Public sector asset purchases (PSPP).

• Forward guidance ✓ On policy interest rates purchases and reinvestments. ✓ On flows and stocks of asset purchases/reinvestments.

Most Recent ECB Monetary Policy Decisions

Governing Council Meeting of 26 October 2017

1. Key ECB interest rates were kept unchanged and we continue to expect them to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases.

2. From January 2018 our net asset purchases are intended to continue at a monthly pace of €30 billion until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase the APP in terms of size and/or duration.

3. Reinvest the principal payments from maturing securities purchased under the APP for an extended period of time after the end of its net asset purchases, and in any case for as long as necessary.


The ECB’s Non-standard Monetary Policy Measures

ECB Monetary Policy Measures Since June 2014

• Policy interest rates at or below 0: ✓ Deposit facility rate lowered in four steps from 0% to –0.4%.

• Credit operations ✓ Targeted longer-term refinancing operations (TLTRO 1 and 2), linked to

bank loans to non-financial corporations and households.

• Asset purchase programmes ✓ Purchases of private sector securities (ABS, covered bonds, corporate

securities) ✓ Public sector asset purchases (PSPP).

• Forward guidance ✓ On policy interest rates purchases and reinvestments. ✓ On flows and stocks of asset purchases/reinvestments.

Most Recent ECB Monetary Policy Decisions

Governing Council Meeting of 26 October 2017

1. Key ECB interest rates were kept unchanged and we continue to expect them to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases.

2. From January 2018 our net asset purchases are intended to continue at a monthly pace of €30 billion until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase the APP in terms of size and/or duration.

3. Reinvest the principal payments from maturing securities purchased under the APP for an extended period of time after the end of its net asset purchases, and in any case for as long as necessary.


4. Continue to conduct the main refinancing operations and three-month longer-term refinancing operations as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the last reserve maintenance period of 2019.

Sources: Bloomberg, ECB, ECB calculations. Notes: The impact of credit easing is estimated on the basis of an event-study methodology which focuses on the announcement effects of the June-September package; see the EB article “The transmission of the ECB’s recent non-standard monetary policy measures” (Issue 7 / 2015). The impact of the DFR cut rests on the announcement effects of the September 2014 DFR cut. APP encompasses the effects of January 2015, December 2015, March 2016, and December 2016 measures. The January 2015 APP impact is estimated on the basis of two event-studies exercises by considering a broad set of events that, starting from September 2014, have affected market expectations about the programme; see Altavilla, Carboni, and Motto (2015) “Asset purchase programmes and financial markets: lessons from the euro area” ECB WP No 1864, and De Santis (2015), “Impact of the asset purchase programme on euro area government bond yields using market news”, ECB WP No. 1939. The quantification of the impact of the December 2015 policy package on asset prices rests on a broad-based assessment comprising event studies and model-based counterfactual exercises. The impact of the March 2016 measures and the impact of the December 2016 measures are assessed via model-based counterfactual exercises. The response of long-term yields to a conventional 100bps monetary policy shock (memo item) is computed by (i) regressing the daily change in sovereign yields on the policy surprise, which is identified as the change in the 2y OIS instrumented with its intra-daily change around Governing Council policy meetings and (ii) re-scaling the policy shock to 100bps. The sample spans January 2005 to June 2014. Lending rates refer to rates to NFCs. *Changes in lending rates are based on monthly data, the reference period for which is May 2014 to August 2017. Latest observation: 9 October 2017. (LHS chart) and 4 October 2017 (RHS chart).

Chart 7: Key financial indicators since June 2014 and impact of policy measures (lhs chart: percentages per annum; rhs chart: basis points unless indicated)


Conclusions

• The economic expansion in the euro area continues to be solid and broad-based.

• While the ongoing economic expansion provides confidence that inflation will gradually head to levels in line with our inflation aim, it has yet to translate sufficiently into stronger inflation dynamics.

• The recalibration of our asset purchases reflects growing confidence in the gradual convergence of inflation rates towards our inflation aim, on account of the increasingly robust and broad-based economic expansion, an uptick in measures of underlying inflation and the continued effective pass-through of our policy measures to the financing conditions of the real economy.

• Therefore, an ample degree of monetary accommodation remains necessary for underlying inflation pressures to continue to build up and support headline inflation developments over the medium term.

Chart 8: Bank lending rates on loans for non-financial corporations

(percentages per annum)

Chart 9: MFI loans to non-financial corporations in selected euro area countries


Source: ECB. Notes: The indicator for the total cost of lending is calculated by aggregating short- and long-term rates using a 24-month moving average of new business volumes. Latest observation: August 2017.

Source: ECB. Notes: Adjusted for loan sales, securitization and cash pooling activities. Latest observation: August 2017.


Conclusions

• The economic expansion in the euro area continues to be solid and broad-based.

• While the ongoing economic expansion provides confidence that inflation will gradually head to levels in line with our inflation aim, it has yet to translate sufficiently into stronger inflation dynamics.

• The recalibration of our asset purchases reflects growing confidence in the gradual convergence of inflation rates towards our inflation aim, on account of the increasingly robust and broad-based economic expansion, an uptick in measures of underlying inflation and the continued effective pass-through of our policy measures to the financing conditions of the real economy.

• Therefore, an ample degree of monetary accommodation remains necessary for underlying inflation pressures to continue to build up and support headline inflation developments over the medium term.

Chart 8: Bank lending rates on loans for non-financial corporations

(percentages per annum)

Chart 9: MFI loans to non-financial corporations in selected euro area countries


Source: ECB. Notes: The indicator for the total cost of lending is calculated by aggregating short- and long-term rates using a 24-month moving average of new business volumes. Latest observation: August 2017.

Source: ECB. Notes: Adjusted for loan sales, securitization and cash pooling activities. Latest observation: August 2017.


163

ECB Monetary Policy Measures Since June 2014: Overview

Deflation risks at the time of the APP announcement have virtually disappeared

Chart 11: Risk neutral probability density function of euro area inflation over the next five years

Sources: Bloomberg, ECB calculations. Notes: Implied probability density functions are computed from 5-year maturity zero-coupon inflation option floors. Risk neutral probabilities may differ significantly from physical (or “true”) probability distributions. Shaded areas indicate the probability mass assigned to an average inflation rate below 1.5% and below 0% over the next five years.


164

Policy interest rates moving into negative territory

Impairment of the transmission mechanism of monetary policy

Chart 12: ECB key interest rates and short-term money market rates (percent per annum)

Source: ECB. Latest observation: 4 September 2017.

Chart 13: Pass-through of changes of the ECB MRO rate to bank lending

rates: 2002-2003 (September 2002 – October 2003)

Chart 14: Pass-through of changes of the ECB MRO rate to bank lending rates:

(May 2012 – May 2014)

Sources: Reuters, ECB calculations. Notes: Last observation for lending rates May 2014 (right chart), or October 2003 (left chart). The grey ranges define the 20th to 80th percentile of short-term bank lending rates for small-sized loans (<€1mn) to NFCs.


164

Policy interest rates moving into negative territory

Impairment of the transmission mechanism of monetary policy

Chart 12: ECB key interest rates and short-term money market rates (percent per annum)

Source: ECB. Latest observation: 4 September 2017.

Chart 13: Pass-through of changes of the ECB MRO rate to bank lending

rates: 2002-2003 (September 2002 – October 2003)

Chart 14: Pass-through of changes of the ECB MRO rate to bank lending rates:

(May 2012 – May 2014)

Sources: Reuters, ECB calculations. Notes: Last observation for lending rates May 2014 (right chart), or October 2003 (left chart). The grey ranges define the 20th to 80th percentile of short-term bank lending rates for small-sized loans (<€1mn) to NFCs.


Expansion of central bank balance sheets

Hurting bank profitability?

Chart 15: Development of central bank balance sheets during the crisis (January 2007 = 100)

Source: ECB, Federal Reserve, Bank of England, Bank of Japan. Notes: The BOE balance sheet is approximated after the 24 September 2014 since the institution only discloses 90% of its consolidated balance sheet after this date. Latest observation: 1 September 2017 (Fed, BOE), 25 August 2017 (ECB, BOJ).

Chart 16: Bank profitability and monetary policy 2014-2017 (Return on assets, percentage points)

Source: EBA, ECB and ECB estimates. Notes: Deviation from no policy action scenario. Capital gains based on data on a consolidated basis for 68 euro area banking groups under direct ECB supervision and included in the 2014 EU-wide stress test. Euro area figures calculated as the weighted average for the countries included in the sample using Consolidated Banking Data (CBD) information on the weight of each country’s banking system on the euro area aggregate. Effect on net interest income based on aggregate BSI data and obtained by simulation of the interest income and interest expenses based on estimates of the effect of APP on bond yields, lending and deposit rates, excess liquidity and economic growth taking into account BMPE projections for interest rates and credit aggregates. Effect on credit quality based on the median of estimates obtained from a suite of empirical studies.


Expropriation of savers?

Chart 17: Distribution of deposit rates to HHs and NFCs (x-axis: deposit rates in percentages per annum, y-axis: frequencies in percentages)

Source: ECB. Note: Deposit rates on new business as reported by individual banks for each of the available product categories. The dotted lines show the weighted average deposit rates in Jun-14 and Aug-17.

Chart 18: Households’ interest flows 2014Q2–2017Q1 (percentage points of gross disposable income)

Sources: Eurostat and ECB. Note: Changes in household interest payments/earnings are computed as the difference between 2014Q2 and 2017Q1, relative to gross disposable income. 2014Q3 was the first quarter where Eonia became negative. Interest payments/earnings are after allocation of FISIM (financial intermediation services indirectly measured). All calculations are based on 4-quarter moving sums. Latest observation: 2017Q1.


Expropriation of savers?

Chart 17: Distribution of deposit rates to HHs and NFCs (x-axis: deposit rates in percentages per annum, y-axis: frequencies in percentages)

Source: ECB. Note: Deposit rates on new business as reported by individual banks for each of the available product categories. The dotted lines show the weighted average deposit rates in Jun-14 and Aug-17.

Chart 18: Households’ interest flows 2014Q2–2017Q1 (percentage points of gross disposable income)

Sources: Eurostat and ECB. Note: Changes in household interest payments/earnings are computed as the difference between 2014Q2 and 2017Q1, relative to gross disposable income. 2014Q3 was the first quarter where Eonia became negative. Interest payments/earnings are after allocation of FISIM (financial intermediation services indirectly measured). All calculations are based on 4-quarter moving sums. Latest observation: 2017Q1.


Fuelling a property price bubble?

Chart 19: Changes in net interest income across sectors (percentage share of GDP)

Source: ECB. Note: The chart reflects the changes from the second quarter of 2008 to the first quarter of 2017, and from the second quarter of 2014 to the first quarter of 2017, in the four-quarter moving average of net interest income. To exclude the impact of variations in the stocks of assets/liabilities on net interest income, the changes are computed by applying the asset and liability rates of return on the notional asset and liability stocks in the first quarter of 2008 and the first quarter of 2014, respectively. Changes in net interest income are expressed as percentages of GDP, with GDP fixed at the respective starting points.

Chart 20: Real household loans around starting period of house price booms (indices, normalised to 100 at T=trough; T=2013Q4)

Sources: BIS, ECB, OECD, ECB calculations. Notes: Based on data from 1975Q1 to 2017Q2 for euro area countries. Trough (starting point of house price normal increases or booms) identified via quarterly version of Bry-Boschan algorithm by Harding and Pagan, 2002. Dotted line refers to median during house price booms. Grey range refers to interquartile range during normal house price increases.


Decreasing reform incentives for EU Member countries?

Chart 21: Real house prices around starting period of house price booms (indices, normalised to 100 at T=trough; T=2013Q4)

Sources: BIS, ECB, Fed Dallas, OECD, ECB calculations. Notes: Based on data from 1975Q1 to 2017Q1 for euro area countries. Trough (starting point of house price normal increases or booms) identified via quarterly version of Bry-Boschan algorithm by Harding and Pagan, 2002. Dotted line refers to median during house price booms. Grey range refers to interquartile range during normal house price increases.

Chart 22: Budget deficits (general government, in % of GDP)

Sources: EC Spring 2017 Forecast. Notes: data up to 2016; 2017 is a forecast.



Chart 21: Real house prices around starting period of house price booms (indices, normalised to 100 at T=trough; T=2013Q4)

Sources: BIS, ECB, Fed Dallas, OECD, ECB calculations. Notes: Based on data from 1975Q1 to 2017Q1 for euro area countries. Trough (starting point of house price normal increases or booms) identified via quarterly version of Bry-Boschan algorithm by Harding and Pagan, 2002. Dotted line refers to median during house price booms. Grey range refers to interquartile range during normal house price increases.

Chart 22: Budget deficits (general government, in % of GDP)

Sources: EC Spring 2017 Forecast. Notes: data up to 2016; 2017 is a forecast.



Determinants of structural reforms

Chart 23: Current Account (in % of GDP)

Sources: EC Spring 2017 Forecast. Notes: data up to 2016; 2017 is a forecast. (Former) Programme countries include: GR, IE, CY, PT and ES.


Negative spillovers to the rest of the world?

ECB unconventional monetary policy measures caused

➢ In the very short term : • Positive confidence effects across Europe, boosting asset prices. • Depreciation of the euro.

➢ In the short to medium term : • Positive spillovers to GDP growth, inflation and asset prices. • Work through financial channels and trade.

➢ Compared to the Federal Reserve unconventional monetary policies • ECB spillovers to non-European economies significantly smaller. • In particular concerning capital flows.

➢ How to harness positive spillover effects? • Whether spillovers are beneficial depends on business cycle correlation

with the euro area, which is very high for non-euro area European economies.

• Pro-cyclical spillovers can be addressed by adequate macro-prudential and fiscal policies.

Documents

Central Bank Papers on Monetary Policy Frameworks in the ... · in implementing the monetary policy objectives as it gives the CBUAE early warning signals of developments in the local