The Monetary Policy Setting In Ghana – Issues And Prospects
GOVERNOR'S SPEECH - ISSER-MERCHANT BANK LECTURES
HIGHLIGHTS OF THE SIXTH ISSER-MERCHANT BANK ANNUAL ECONOMIC LECTURES DELIVERED BY THE GOVERNOR OF THE BANK OF GHANA, DR. PAUL A. ACQUAH ON JUNE 14TH 2005
1. Mr. Chairman, Director of ISSER, Distinguished Ladies and Gentlemen, I would like to thank ISSER and Merchant Bank for their invitation to deliver this year's annual ISSER-Merchant Bank lecture. I would also like to thank you for taking the time to be here. My topic this evening is on the “Monetary Policy Setting in Ghana – Issues and Prospects”. There are certainly many issues but I would like to say from the outset that the prospects are good.
2. Mr. Chairman, monetary policy is essentially the use of interest rates and the money supply to influence economic variables. In this regard, the monetary policy process is not different in Ghana from any other country that follows standards of international good practice for the conduct of macroeconomic policy. The context may be different, in terms of the structure of the policy framework including the government's overall economic strategy, the state of public finances and the financial system, but not so different to alter the monetary policy process in a fundamental way: of course, the regulatory regime and the efficiency of markets have a bearing on the transmission of monetary policy actions through the economy.
The Role of the Monetary/Fiscal Framework
3. Mr. Chairman, as we are all aware, the weaknesses in the economy were exposed by commodity price shocks in 1999 and 2000. The prices of Ghana's major exports (cocoa and gold) plummeted on the international markets while the price of its major import (oil) increased, in the midst of a surge in spending and a growing budget deficit. Fiscal and monetary policy were not firm, the public sector's borrowing led to a large build-up debt, with an increased dependence on external donor inflows that fell short. The economy plunged into high inflation and exchange rate depreciation and the currency collapsed.
4. Given this background, and with a commitment to anti-inflation strategy and price stability, and enshrined in the Bank of Ghana Act (2002), the focus of the fiscal and monetary policy has been to engineer a switch from a high inflation, interest rate and exchange rate depreciation regime to a low inflation and interest rate regime with exchange rate stability.
5. This has meant a major shift in macroeconomic policy from one of considerable fiscal relaxation and monetary accommodation to one of fiscal and monetary stringency. The consequence has been a dramatic reversal in economic trends. By the end of December 2004, the developments in all the major indicators show a fundamental change in stabilising macroeconomic conditions has taken place in the economy.
6. Fundamentally, the economy has moved from a high inflation environment on to a path of disinflation and macroeconomic stability, with reduced fiscal deficits and net government repayment of debt, increasing external reserves, and relative exchange rate stability.
I should note that: · Annual end-period inflation declined from 40.5 percent in December 2000 to 11.8 percent in December 2004. · Interest rates (e.g. the 91-day Government of Ghana Treasury bill rate and the Bank of Ghana Rate) are at their lowest level since 1985. · Exchange rate depreciation at (2.2 percent in 2004) is at its lowest since 1983. Indeed, the cedi has stabilised within a narrow band around the major currencies. · The overall fiscal deficit has been steadily reduced from 9.0 percent of GDP in 2000 to 3.2 percent of GDP at the end of 2004, the lowest level since December 1996. · The Domestic debt/GDP has declined from 21 percent in December 2001 to 15.2 percent by 2004. · The annual growth rates of the monetary aggregates have come down substantially, with reserve money growth below 20 per cent. · Gross international reserves at then of 2004, $1.7 billion is the highest on record.
7. On the basis of this performance, the country has also obtained its first sovereign rating with a subsequent upgrade in 2005, laying the foundation for gaining access to international capital markets.
8. Mr. Chairman, the performance of the economy in 2004 is particularly illustrative of the fundamental shift in economic regime. It should be noted that as in 2000, 2004 was an election year. In addition, the economy faced a deteriorating terms of trade as a result of higher international oil prices 2000 and 2004. (Infact, the oil shock in 2004 was more severe than in 2000.) The response of the economy to these shocks was very different. While in 2000, inflation was increasing, the exchange rate depreciating, interest rates rising in nominal terms, international reserves declining, and output contracting, in 2004 the opposite was the case because the underlying fiscal and monetary policies were different. It is an illustration that the effects of a shock are much more muted in a more stable environment than otherwise.
9. Bank of Ghana Act and Central Bank Independence
This historic Act specifies among other provisions that:
· the primary objective of the Bank is to maintain price stability “independent of instructions from Government or any other authority”. This has refocused the central bank on the major task of inflation control and away from the developmental activities that characterised the Banks' operations in the past.
· a Monetary Policy Committee will be responsible for formulating monetary policy, which should bring transparency to the central bank's operations and its communications with the public
· government borrowing from the central bank in any year shall be limited to 10 percent of its revenue, which ties the hands of government and the central bank in a way that is much stricter than the 20 percent ceiling which prevails in the CFA zone countries, for example.
The new Monetary Policy Process – Inflation targeting
10. The Bank's Monetary Policy Committee (the MPC), modeled after that of the Bank of England, sets interest rates every other month, and communicates its decision to the public, “independent of the instruction from Government or any other authority” (Bank of Ghana Act 2002). In its work, it has established a commitment to anti-inflation strategy using the inflation- targeting regime.
Bank of Ghana Prime Rate
11. To tighten the link with liquidity management and inflationary expectations and the transmission of monetary policy actions, the central bank introduced a “Prime Rate” in March 2002. It is the rate at which the central bank would provide overnight funds to banks and thus should influence the interbank market rate and interest rates generally consistent with its monetary policy stance.
12. In reaching its decision on the Bank of Ghana Prime Rate, the MPC meets over three days to examine and analyze a considerable amount of data on the economy, including the fiscal outlook, monetary and inflation developments, external sector, financial stability, and the real sector of the economy. Such information is required to give context to the decision and to provide a basis for the market participants also to formulate a view. There is a popular notion that with its eye on inflation, the MPC does not give a lot of attention to the real sector of the economy. In fact, the MPC analyzes a lot of data on real sector developments and undertakes surveys of 45 companies covering all sectors of the economy every two months. (The object of creating a low inflation environment is to allow sustained economic growth to take place, although low inflation is good for its own sake and essential for growth.)
13. To address the existing gap in information about developments in the real sector of the economy, the Bank of Ghana introduced a new economic indicator, the Composite Index of Economic Activity (CIEA), to complement its regular surveys of business. The CIEA measures real sector activity including output of selected key enterprises, industrial electricity consumption, domestic VAT, port activity, imports, exports, and employment contributions, The results from the CIEA and the surveys of business since 2003 indicate that economic activity has been on the increase.
14. The Bank of Ghana is operating an inflation-targeting regime as has become the practice of many central banks. This has been based on controlling liquidity and setting interest rates to reflect the underlying cost of capital and steering inflationary expectations.
· Monetary policy has focused on shifting the focus from dealing with volatile exchange rate expectations to a focus on inflation expectations which is the monetary policy target in the transparency of and with the help of the MPC process.
· A Press Conference is held by the Committee at the end of each bi-monthly meeting, and a lot of statistical information in the form of reports is released to the general public. This process of communication is a novel departure from past practice and seeks to provide as much information on the economy and the stance of monetary policy for the press/public to take a stake in its objectives.
15. In coordination with the fiscal stance, monetary policy instruments have been deployed to reduce the rate of growth of the monetary aggregates and diffuse inflationary expectations. The result has been a slow down in the growth of the monetary aggregates which has become more pronounced during the first half of the year especially as the seasonal liquidity associated with the cocoa crop began to unwind. While this process of slowing down monetary growth was helped initially by the reduction in fiscal deficits, it had to contend with the surge in exports and other inflows. A policy of sterilization of liquidity was implemented to deal with this potential problem. The policy of sterilization was also made easier because we were starting from a low reserve base and therefore had to balance our reserve build-up objectives with domestic liquidity concerns.
16. Mr. Chairman, monetary policy is a dynamic process and in the Bank of Ghana like any other institution has to constantly review the way it does business. The Bank of Ghana is introducing a number of policy reforms aimed at:
· Increasing the efficiency of the transmission of monetary policy · Gradually moving towards a separation between Bank of Ghana open market operations (OMO) and funding the Public Sector Borrowing Requirements (PSBR) · Enhancing the development of the secondary market · Enhancing the transparency and competitiveness of the interbank money market and making it the primary money market for the banking system
17. In the Money market:
· The BOG Prime Rate will continue to signal the direction of short-term interest rates and act as a reference rate for some facilities, such as the repo.
· Overnight Repo and reverse repo facilities will now be available, in addition to existing facilities, at the BOG Prime Rate and reverse repo rate respectively. This will provide the BOG a presence on the interbank market and increase its ability to influence rates on this market.
· The new framework also aims at encouraging banks to use the interbank market as their primary source of liquidity and therefore has in-built incentives to ensure that a recourse to the central bank is not the first choice of banks. To accomplish this the BOG'' new framework widens the existing interest rate corridor for its money market operations from 1.0 percent to 3.0 percent.
· Reverse repos will be undertaken at 2.0 percentage points below the prime rate rather than the 1.0 percent under the existing framework. This will achieve the objective of ensuring that the reverse repo rate is below the interbank market rate. In this situation, banks should find it more attractive to lend to other banks than to the central bank.
· Furthermore, to encourage banks to deal with each other in squaring up their liquidity positions in meeting reserve requirements, the new BOG framework provides that on the final day of the maintenance period for reserve requirements, fine-tuning repos will be available at 1.0 percent above the BOG Prime rate.
· Transparency on the interbank market would be enhanced through the provision of information on interbank market transactions and quotations via a reuters screen available to all banks on a real time basis.
· Periodic auctions will be held for purposes of Open Market Operations (OMO) by the bank of Ghana, separate from the auction for the Public Sector Borrowing Requirement (PSBR) of Government. In the meantime, the current auction for the PBBR and OMO will continue.
18. The Bank of Ghana is also making major changes on its liquid reserve requirements for banks. Currently, Banks are required to hold 9.0 percent of their eligible deposits as primary reserves at the central bank. In addition, banks are required to hold 35.0 percent of their eligible deposits as secondary reserves, in the form of treasury bills and medium term government securities.
19. The high level of reserve requirements is the legacy of high fiscal deficits and the need for the government to have a captive market to finance these deficits. The economic landscape has however changed in recent years as the new fiscal/monetary policy framework has resulted in a disinflation process that has taken hold. In balancing the stability of the economy with the efficiency of the market, the BOG's new policy framework contains the following changes to reserve requirements:
· The primary reserve requirement will continue to be 9.0 percent
· The secondary reserve requirement is to be reduced from 35.0 percent to 15.0 percent
· The requirement that Banks hold 15.0 percent of deposits in the form of medium term securities would no longer apply.
These changes in reserve requirements will take effect on July 1, 2005
Sustaining The Progress – The Outlook
20. High and variable inflation creates incentives for misallocation of resources and uncertainty that makes it more difficult for firms, consumers and savers to make decisions. Inflation leads to arbitrary and inequitable redistribution of incomes, it serves as a tax on incomes and hits hardest at low-income groups, especially the poor. No lasting benefits can accrue from high inflation. A periodic average inflation rate of some 20 per cent a year over a ten-year period cannot fall within the definition of price stability. It is volatile and opens the economy to the downside risks of inflation surges. Therefore, economic stabilization, moving an economy onto the path of low and stable inflation is in itself a desirable and necessary policy goal.
Breaking the single digit Inflation barrier and joining the Club
21. The issue as we look ahead is how to scale-up growth rates without endangering price and financial stability. Put differently, the emphasis is on building the structural foundations of stability and accelerated economic development in an environment of low single digit inflation. This is a complex process. There are several theories and approaches as to how to grow economies. However, there is a broad consensus on what strategies would work when adapted to specific country circumstances. There is also a litany of measures that policies could focus on, beyond concerns for macroeconomic stability. These include external sector liberalization, strengthening public institutions, improving governance, promoting a sound banking system, privatization, and reforms of customs and tax administrations in the context of comprehensive fiscal consolidation and public resource management.
In sum, growth comes out of a continuing process of structural reforms in an environment of stability.
22. One of the major structural impediments to the development of the financial sector is the cash-based nature of the economy. As I noted earlier, this complicates monetary management and weakens the transmission mechanism of monetary policy. It is therefore important that we vigorously pursue an integrated Payments System for the entire financial sector, including the rural banks and microfinance institutions. The commercial banks are leading the way with a common payments platform that will in the near future allow bank customers to have access to the ATMs of every bank in the country. The prospects are for a modernized payments system with a focus on electronic settlements.
23. In conclusion, the fiscal and monetary policy framework initiated in 2001 has so far brought about significant progress in stabilizing the economy with improved fundamentals and outlook. The economy is making the transition to a stable low inflation regime, and low interest rate environment with relative exchange rate stability. The lessons that have been learned in this process call for consistent implementation of the fiscal/monetary policy framework and structural reforms to sustain the process, to lay solid foundations for robust growth and wealth creation for the benefit of all.
Thank you for your attention.