Monetary Policy and Financial Institutions of Kenya
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The world is turning into a “demon” to its own people as many are living in deplorable situations that are hardly bearable. The price level have risen sharply in the recent past coupled with dwindling wage levels and declining growth rate, especially, in majority of African countries where poverty has embedded itself to an extent that people in these countries live below one dollar per day. However, majority of governments have embarked on instituting major reforms through introduction of avant-garde monetary policy schemes, which forge the way forward through which the monetary authority re-design its policy by focusing primarily on price stability as the primary objective.
In the last twenty years, majority of both developed and emerging economies respectively have embarked on IT framework as their best choice in conducting monetary policy, with none of inflation countries targeters abandoning the framework, save for Finland and Spain, that have already joined the European Monetary System (EMS) in late 90's. IT-framework; an approach to management of monetary policy was pioneered by the New Zealand Government in 1990 after it abandoned its pegged exchange rate five years later. By the year 2009, over twenty-five countries comprised of developed, emerging, and developing countries around the world had so far espoused the IT-Framework and have reported greater achievement of low inflation rate. Majority of these countries mainly from Latin America, East Asia and United Kingdom had experienced high bout of inflation and financial crises exacerbated by their former monetary policy regimes. These not only resulted to sacrificing output and employment but also resulted to severe increase in international capital flow leading to a switch to floating exchange rate.
1.1 Historical Background
In relation to many other African countries, the monetary policy and financial institutions of Kenya has developed rapidly within the last two decades and probably more advanced than other countries at a similar stage of underdevelopment. Kenya opened its own Central Bank in September 1966 with the hope that, it would at least generate secondary expansion by facilitating the creation of bank credit and accelerate the process of monetization of the economy's subsistence sector, in spite, of its openness and sensitivity to fluctuations of primary commodities.
The next decade following the establishment of her Central Bank witnessed interesting changes in Kenya's monetary and banking policies as the oil shock of 1973 created inflexibility in the foreign exchange reserves as they declined considerably. Hence, the magnitude and speed of reduction in credit expansion were not adequate to show the decline in foreign exchange reserves. In fact, the fear that tight monetary policy induced from outside could hamper the rate of development at home led to feeble corrective measures such as restraining inflation impact due to price boom of exports, which coincided with expansionary monetary policy under a low profile of interest rates.
In the early 1980's and 1990's Kenya experienced high inflation resulting from a prolonged spell of drought and political instability that resulted from introduction of a multiparty system in the Kenyan political history in late 1980 and also general elections followed later in 1992. Besides, in 2002, the growth per capita was negative due to high corruption of the highly ranked government official and political interferences of major decision-making organs of government including the Central Bank of Kenya, as it could not carry out its mandate freely. In the year 2008, Kenya faced another dark moment in terms of its political stability as the whole country went into turmoil due to the highly disputed general elections' of 2007. The once giant of East African countries went down into “ashes” and major sectors of the economy especially the financial sector got hurt the most. Since then, it has been very difficult for the resurgence of economic stability, political stability and financial institution even after the power brokering that gave birth to a coalition government in that same year. However, in late 2010, the coalition government of Kenya gave hopes to recovery of major sectors of the economy when the New Constitution unanimously voted into existence in a referendum. This Constitution has brought about major reforms in the financial and political arenas more specifically in the Central Bank of Kenya as per se; hence, major changes are expected to be instituted by CBK for an effective and independent monetary policy conduct.
1.1.2 Road map of Kenya towards adoption of ITF
1.1.2a) Central Bank of Kenya main policy objective
The amended Central Bank of Kenya Act of 1996, CAP 491(4) permitted the Bank's operational autonomy in the conduct of monetary policy and mandated price stability as one of its primary objectives through formulation and implementation of such principal object of the bank, thus, promoting the long-term goal of economic growth. In fact, the Central Bank of Kenya does not announce an inflation target; instead, it uses money growth reserve as her main nominal anchor of which the repo rate forms its main operational target. It is in this perspective that the CBK monitor and control inflation rate through interest rate transmission channel as a way of conducting monetary policy. Apart from the main objective that is price stability, the Bank has a mandate to balance its inflation goals against other goals such as exchange rate stability and promotion of liquidity, solvency and steady-market back up while ensuring equilibrium in domestic and external payments.
1.1.2b) Central Bank of Kenya attributes that favor ITF adoption
The Bank like any other bank of its caliber is mandated by the legislation to carry out its objectives in a more coherent and consistent manner without any external interference, thereby commanding greater central bank independence. The ‘Old' Constitution of the Republic Kenya of (1963) and ‘Newly' Promulgated Constitution of the Republic Kenya of (2010) have further strengthened the Bank's Act, thereby, empowering the bank to carry its main objective without political interferences and curbing time-inconsistency trap.
The appointment and removal of the CEO of the Bank (governor) and his/her deputy rest with the president discretion for a period of four years term in office unless stated otherwise. In connection to the governor term of office termination, the president has a directive to appoint a tribunal comprised consisting of a chairperson and two members who hold offices in High Court or Court of Appeal. This tribunal enquires on matters related to termination of such appointments and make recommendation to the president. Nevertheless, these might undermine the Banks credibility in upholding autonomy in case the termination of the governor might be unlawfully since the appointing authority might compromise the tribunal to favor his/her decision.
In conformity with the Act CAP (491), the MPC is hereby required to forward a report at least every six month to the Minister detailing all dealings the bank is undertaking hence the Minister shall table the MPC report before the Parliament for further amendment and deliberations. The Bank is exempted from any taxation whatsoever in respect to losses or profits. The Bank's books of records and financial statements subjected for auditing by the Controller and Auditor General only if the Minister of Finance deems it appropriate for such auditing.
Both Governor and Deputy Governor are indebted to adhere to the bank in totality and prohibited from engaging in any other paid businesses, professional activities or employment while still in office.
These is in agreement with majority of literature such as (Klomp and Haan 2008) who based their idea on Cukierman Index which states the following inherent features for a central bank to be termed as more independent: - (i) if the governor appointing authority rest with BOG rather than the president, is not prone to relieve of his/her duty, and has a longer tenure in office. (ii), if the government has no tendency to interfere with bank's conduct of business, for example, in policy formulation and implementation; if there is a greater independence be it of legal instruments or goal instruments; and also if the government has no capacity to borrow from the bank. (iii) last but not least, if the bank main objective is price stability.
1.1.2c) Economic Independence of CBK
Kenya has also experienced tremendous financial innovations intensifying greater implications to monetary policy transmission mechanism. The Bank is empowered to act as a fiscal agent of the government or any public entity. Similarly, the advance made by bank to the government is supposed to be secured with securities issued by government, of which are supposed to mature before twelve months, bears interest at market rate, and are advanced for a short-term period to the government. In compliance with the statute, the CBK has an authority to grant loans and advances not exceeding three years in fixed period to government as a Deposit Protection Fund Board (DPFB), while the bank has mandate to lend or give credit to public entity, although, it is limited in extending such credits.
The main interest is built on the various chief features associated with the introduction of inflation targeting framework by most of the Central Banks' of both developed economies and transitional economies around the world; borrowing heavily from various aspects of literature that have analyzed greatly the development of this framework in order to determine the viability of the framework in low income countries such as Kenya. indeed, little has been done in A model specific to the needs of Kenya will be developed while building a general structure within the framework of an ITF so as to distinguish between group characteristics of the inflation-targeting and non-targeting central banks since its inception, and the relationship between various variables mentioned in the hypothesis.
In addition, the paper depicts lessons learned by countries that have already adopted the strict ITF since 1990s. What become apparent evident in process of this review, however, is that several contributory problems must first be solved before forming an informed judgment on the likelihood of low-income countries embracing the framework. The first of these problems is whether there are impetus and aspect linked with decisions to move from a specific monetary practice to another. Second problem revolves around the feasibility of other policy designs of monetary policy such as exchange rate regime and central bank independence Third problem will address chief pitfalls that could prevent low-income countries from embracing this policy design. The study hypotheses investigates the relationship between conditions that lead to adoption of inflation targeting framework in developed economies and examine if these pre conditions have a replicate effect in low income countries.
The other parts of the paper shall be structured as follows: In section II, assess modification of monetary policy conduct under ITF by various developing countries central banks', the cons and pros of shifting to such strategy. In section III evaluate the exchange rate transition and its role to inflation targeting framework more specifically the following interrelated issues will be taken into considerations: the role of nominal exchange rate it plays as a nominal anchor, the costs associated with the real exchange rate overvaluation; and the approach for exiting the pegged exchange rate. Section IV reviews the role of the central bank independence since it forms the core tenet of conjecture that is built around the inflation targeting framework.Likewise, other contributory factors to embracing the framework will be captured in this Section. The paper concludes with the policy recommendation and the way forward.
1.3 General Salient features, Implementation and Experience
A better strategy for monetary policy is built on the following inherent characteristics as summarized by Svensson Lars 1997; Friedman, 1990; McCallum, 1990 that is, it is supposedly to be highly correlated with the goal and has a tendency to be controlled by central bank with much ease than the goal itself. Similarly, the public and the central bank should be able to comply to it with much ease than the goal. In addition, transparency is of greater importance in terms of the efficiency and effectiveness of the bank communicating to the public its objective and procedure of conducting its monetary stance.
Literature from (Bernanke and Mishkin 1997), Bernanke et al. (1999) and (Svensson Lars 1997) has vehemently mentioned various elements that form this framework which includes. First, price stability is formally chosen as the main intent of monetary policy, which indicates the monetary stance and the central bank's principle of appraising its performance. Second, the central bank issues a declaration, which categorically states the numerical target for inflation within a specific, horizon-thus the bank has the latent to lessen the possibilities of falling into time inconsistency trap in carrying out its primary goal.
Third, either the government can opt to choose the target, independently or collectively with the central bank, which is associated with appropriate changes in the central bank's law thus enhancing instrument independence of the institution in achieving its target. Fourth, the ITF promotes high transparency in the conduct of monetary policy thus enabling flow of information from the central bank to the public and government. Svensson Lars (1997) stated that, when the authority anticipate the policy target deviation, the strategy should be attuned in such a way it is neither contractionary nor is it expansionary in accordance with keeping the policy on target. On this background, the IT-framework work best in forecasting future inflation, that is, the relevant information for forecasting monetary policy is of greater importance in predicting future inflation. Indeed, this transparency of inflation targeting forms a better juncture in terms of motivating and focusing the activities inside the central bank. More so, there is high tendency of central bank accountability, which is often outlined in case of breach of inflation target, meaning it helps in clarifying what the central bank is capable and incapable for it to be accountable.
Although, inflation targeting has proved to be the best modern strategy it does not lack some criticism or problems that characterizes it in terms of implementation and monitoring. For instance Svensson Lars (1997) has described some of the inherent problems that makes this strategy ineffective, which includes: central bank's inability to restrain inflation due to the fact that, previous decisions and contracts play a vital role in determining current inflation. In other words, the authority can only have power over the future inflation. In addition, monitoring and evaluation of monetary policy by public faces a greater set back due to the inadequate control of inflation.
32.0 Literature Review
A large body of literature has been developed to analyze the effectiveness of an explicit numerical anchor since such framework was adopted in early 1990s. There exists a large number of literatures on major development of Inflation Targeting Framework since its inception in developed countries and emerging economies. However, there is little development in low-income countries in regards to adoption and implementation of this framework varies greatly in most of these countries because of lack of a well-developed financial market, inadequate fiscal position, political interferences and also lack of market integration in majority of them thus posing a bigger challenge to welcoming this framework as a way of monetary policy conduct. Therefore, the section borrows heavily from past studies that have since been done in order to demarcate the gaps that have made the framework ineffective.
3.1 Transition to Inflation Targeting Framework: Central Bank of Kenya
In the past decades, the monetary policy encountered by most of the emerging markets' economies has been depressing, these resulted to extreme periods of monetary instability, vacillating from high inflation, to colossal capital flight, and thereby led to downfall of many financial systems. However, the forecast for successful monetary policy in the majority of countries in transition have so far been augmented. This has been typified by considerable decline of inflation rate in Latin America region as an example of an emerging region, which dramatically fell from an average of above 400% in 1989 to less than 10% (Mishkin & Savastano, 2001)
According to Morande and Schmidt-Hebbel (997), “this objective of inflation control has been interpreted by public as formal targets or “hard” targets.” Thus enables the central bank to be more accountable by explicitly announcing a multi-year target for inflation. Downs and Vaez-Zadeh (1990) declared that “during the transition it is not possible to forecast market behavior…..[s]ince the old money-model is bound to be obsolete and perhaps of little use” (318). Indeed, the ‘old fashioned' regime of money-growth targeting framework has proved inefficient in the recent past, although the Central Bank of Kenya has been able to maintain inflation rate as low as possible. Above all, the de-regulation of economic activities in the early 1990s marked a major landmark in the conduct of monetary policy in Kenya in terms of objectives, instruments and institutional framework.
Mwega 1990(a) developed a model that sought to explain the changes in the CPI Growth e.g. real income (T) changes, changes in money supply (M2), changes in import prices and changes in previous year's inflation rates (Pt-1) were the expansionary variables. In these results, he found money supply to be a significant determinant of inflation. Similar study was done by Ndung'u (1993) where he did a comprehensive study on the dynamics of the inflationary process in Kenya for the period 1970-1991. He used a monetarist model, named the error correction form of model and empirically showed monetary growth, interest rates changes, real income growth and excess money printing which were significant determinants of inflation in Kenya assuming a closed economy. When he included the external economy, he found the exchange rate had a significant effect on the domestic price level. The results of his study indicated inappropriate government policies (monetary and fiscal) resulted lack of control of inflation especially in 1980-1990 where inflation level escalated.
Mishkin and Schmidt-Hebbel (2007) in there panel data analysis comprising of both inflation-targeting industrial countries and non-inflation targeting industrial countries, argued that ITF has helped these countries in achieving stable inflation rate in the long-run where they are attributable in oil-prices and exchange rate shocks, and that are associated with strengthening of monetary policy independence and enhanced policy efficiency.
Taguchi and Kato (2010) assessed the performance of the IT in East Asian economies where they adopted a co-integration approach between money and inflation. The estimation results were that, the ITF in the sample of few selected economies, except for Philippines, proved to work well as an anchor for controlling inflation through speeding up price adjustments (stabilizing inflationary expectations) against money supply in the context of floating exchange rate. Similarly, they argued that, “well-functioning inflation targeting framework was consistent with enhanced monetary autonomy under the post-crisis floating exchange rate.”
Aizenman and Hutchison (2008) used a simple empirical model where they estimated panel data for 17 emerging markets for both inflation-targeters and non-inflation targeters and concluded that there was a stable inflation response running from inflation to policy interest rates for inflation-targeters in emerging markets who have anchored their inflation than in non-inflation targeters whose central banks respond less in such markets. Similarly, they argued that “the response to real exchange rate was much stronger in non-IT countries, however, suggesting that policymakers are more constrained in the IT regime where they attempt to target both inflation and real exchange rate and these objectives are not always consistent.”
2.2 An overview of the exchange rate transition and its role in ITF
The Central Bank of Kenya policy objectives have been to protract an exchange rate that will ensure international competiveness while maintaining domestic rate of inflation at low levels through conduct of strict monetary stance.
Calvo and Reinhard (2002) argued that Majority of emerging markets are facing problem in performing inflation targeting due to various issues of how to manage the exchange rate under the condition that their external debt is primarily denominated in U.S. dollars. Therefore, the idea of this framework is believed to work best under floating exchange rate regime.Hence, inflation targeting framework as a monetary policy strategy becomes unrealizable in majority of this countries due to too much concern towards exchange rate volatility.
In recent times, countries with fixed exchange rate have a tendency to fix their domestic currency value to countries whose main objective is to anchor their inflation in readiness to keep inflation rate in check. Most of the countries that have adopted a crawling target or peg their currency tend to devalue at a firm rate in order to keep their inflation rate low vis a vis their counterpart anchoring countries.
These periods marked a milestone that foresaw an accelerated money supply growth and high inflation, but at the same time there was a move to speed up economic reforms and accelerate the pace of liberalization. “An exchange rate regime makes central bank quite accountable because it has clear-cut goals... [b]ut can actually weaken accountability of the Central Banks in emerging- markets countries, by eliminating important signal that can help keep monetary policy from becoming too expansionary” (Blejer, & Šcreb, 1999, p. 41).Also, for the same reasons described in (Mishkin, 1999a) “exchange rate targeting can promote financial fragility and lead to foreign exchange crises that can also lead to full-fledged financial crises with disastrous consequences for the economy”(Cited by Blejer & Šcreb, p.50) .Hence, a continuous adherence of exchange rate regime is probable to have far-reaching impact of economic sluggishness and exacerbate redundancy in the economy, which is exactly what Kenya has experienced in the past. Therefore, the Central Bank should move more assertively by provision of an extra credibility, where policy easing is desired to prevent output reductions, without igniting fears of renewed inflation.
Mishkin & Savastano ( 2001) acknowledged that “ [t]here are three broad monetary policy strategies that can produce an explicit nominor anchor that credibly constrains the discretion of the central bank over the medium : “hard” exchange-rate pegs, monetary targeting, and inflation targeting”. In spite of this, majority of industiralized economies, notably the United States, have used a more or less the same strategy of anchoring inflation. However, it does not explicitly anchor inflation but it implicitly anchor its inflation.......... a monetary policy with an implicit but not an explicit nominal anchor sought of monetary policy strategy to achieve macro-economic goals. Whereas, the three monetary policy strategies have enabled emerging economies to set up institutions and mechanisms that have effectively and efficiently constrained the discretion of their monetary authorities; their suitability to conditions in different markets differs according to each strategy that is adopted by each country.
Reinhart and Rogoff (2004) declared that, “Developing countries central banks tend to pursue exchange rate targets that considerably are more deterministic than their official pronouncements….[while] a managed floater might be operating a fixed exchange rate or a crawling peg for extended periods”. Likewise, Kenya has undergone myriad exchange rate regimes in the past mostly driven by various economic cycles, and chiefly the balance of payments deficit. For instance, up to 1974, the exchange rate was pegged to the dollar, but later the devaluation of the currency resulted to a change of the peg to the SDR.1 from 1974-1984 period.
This regime lasted until 1990 when a dual exchange rate system was adopted that lasted till October 1993 when, after a series of devaluations, the official exchange rate was abolished. (Mwega and Ndung'u, 2001) acknowledged that “Kenya adopted a unified and flexible exchange rate in the early 1990s, as part of a market-based reform program designed to improve the investment environment and spur economic growth”(Cited by Ndung'u, 2008). In addition, the (Kenyan Economic Survey, 1995) revealed that the nominal exchange rate suddenly depreciated by about 32%, moving to Ksh38 to the U.S dollar from Ksh 44 to the dollar, and inflation declined from 46% in 1993 to 28.8% in 1994 (as cited in Ndung'u, 2000) as a result of shilling appreciating against dollar in 1995”.
2.3 Central Bank Independence
The literature on ITF in emerging market economies suggests that this monetary policy strategy should be adopted only if some institutional preconditions are met. One of them is Central Bank Independence. Many scholars have given much attention to the central bank autonomy and the role it plays in adopting ITF. Indeed, where central bank is autonomous from government interference it is likely to insulate itself from political pressures to finance government fiscal deficits, which can result to over-expansionary monetary policies that would lead to inflation above target. Cukierman, Webb and Neyapti (1992) constructed Central Bank Index that was designed in two folds that is, legal independence and turnover rate of governors, where both revolved around central bank charters and legislation and the relationship it has over the overall performance of the economy. This paper provides an overview of the mushrooming literature on authority autonomy and precision relating it to the mechanisms through which central banks have in the past adopted greater openness, thereby, focusing more on the role they play in adoption and effective implementation of inflation targeting framework.
(Klomp and De Haan, 2010) used a random coefficient model and they estimated a sample of more than 100 countries to re-examine the relationship between CBI (measured by both governor's TOR and central bank legal indicator) and inflation. They found Central Bank Index to be negatively insignificant with the level of inflation rate of country specific. Most literatures in developing countries have focused on de facto independence as a proxy of CBI that is governor's turnover rate.
Studies of Cukierman, Webb and Neyapti (1992) stated that the average and variance of inflation has a negative correlation to governor's turnover rate in most of the developing. This is due to the fact that, majority of studies has expressed doubts over the reliability of most of indicators used to construct Central Bank Independence indices. Indeed, there exist a greater divergence when it comes to categorization of indicators used to measure CBI incase of high income countries, emerging countries and low income countries.
Cukierman,1994 and Eijffinger and De Haan (1996) have categorically contended that, the CBI indices in majority of high income countries are arises from central bank's laws interpretation and are of great concern to legal independence indicator, whereas, in developing countries de facto independence indicators form the main measure of central bank independence.
Axel Dreher, Jan-Egbert Sturm, Jakob de Haan (2010) used a data set comprising of eighty-eight countries' term of office of central banks governors since 1975-2005. They used logit model to test the likelihood central bank governor term of tenure geting terminated before their legal term in office expires. According to their results, the probability of a TOR as a measure of CBI tend to soar under certain condtions which includes: unstable political system, undue elapse of governor term of service in office and during elections period in self-governing countries. Accordingly, they indicated in their hypothesis that there was a higher chance of the governors getting replaced if there was huge drop out of veto players from the government. Alex, Webb and Bilin (1992)) developed legal independence where they mentioned some of the intrinsic features such as the degree of independence that the authority should bestow to the Bank, and lone dependence on legal component of independence. Besides, the legal independence is significant in ascertaining inflation rate in developed economies. Whereas, turnover rate of governors forms a better turning point of inflation determination in developing countries. Likewise they argued that, in cases where governor legal term of office is shorter than that of government CBI is likely to be compromised by the government, thereby, resulting to increased TOR. More over, the governor is likely to be susceptible from government influence thereby derailing long-term objective of policy formation and implementation under the pretext of political pressure especially during election periods.
(Kuttner Kenneth, Posen Adam 2010), took the same direction and indicated that undue appointment of governor in office result to construed information to the bank in terms of carrying out its primary objective of price stability. For instance, unjustifiable appointment of governor under low inflation periods may reinforce the exchange rate, while the opposite is always true. Since governors appointment seem to contain valuable information regarding the exchange rate and inflation rate.
Gutierrez (2003) indicated that CBI has positieve impact in reducing the chances of governments incurring budget deficits through quasi-fiscal activities. Since such activities can be understood on their inflationary impacts.
Posen and Kuttner (2010) estimated the effect of legal appointment of governor to office exchange rates and bond yield and argued that the main test was to verify the scope to which markets observe that the next governor will bring a swing in policy, whereby he/she is expected to determine the bearing of such swing. This is in conformity with the fact that, the news conveyed may favour either one side due to markets' reaction after such appointment.
2.4 Financial Institutions
Another important prerequisite for successful ITF stressed by the literature is a healthy financial and banking system. Several reasons can be advanced to explain the great importance of well-functioning financial system under inflation targeting framework. First, a sound financial system is essential to guarantee an efficient transmission of monetary policy through the interest rate channel which forms the major channel through which the CBK carries out its main objective of price stability, and more specifically forms an enabling environment of smooth exchange and provision of credit. Second, according to Mishkin (2004), a weak banking sector is potentially problematic to achieve inflation target, because the central bank would be hesitant to raise short-term interest rates for fear that this will impact the profitability of banks and lead to a collapse of the financial system. Third, countries characterized by weak financial institutions are more vulnerable to a sudden stop of capital outflows, causing a sharp depreciation of the exchange rate which leads to upward pressures on the inflation rate (Mishkin, 2004). Fourth, a consequence of lack of large domestic capital markets is an important accumulation of foreign currency external liabilities by firms, households and the government, while their assets are denominated in domestic currency. This liability dollarization makes the financial system more vulnerable to a depreciation of the domestic currency9 by reducing the net worth of borrowers through a balance sheets effect Finally, as outlined in (Woo 2003), a well-developed domestic capital market enables the public treasury to diversify its sources of funds (e.g. by issuing bonds), and then reduces incentive to finance public deficits through inflation.
Moreover, (Cukierman 1992) argues that the degree of financial depth is positively correlated with the level of CBI, in the sense that broad financial markets are more likely to grant their central bank more independence in order to avoid potential disruptions in the process of financial intermediation.
Lucotte, (2010 argues that “for any monetary policy strategy, a sound financial system in essential to guarantee efficient transmission of monetary policy through interest rate channel, but also through credit channel.” (Mishkin, 2004) declared that unhealthy financial system can result to problems in case of embracing the scheme since CB tend to raise interest in the short term for fear of collapse of financial systems. He also argues that exchange rate sharply depreciate due to huge capital outflow thus exacerbating upward pressure on the inflation rate.
2.5 Political institutions
Eijffinger and De Haan, ((1996) noted that, a positive relationship between party political instability and CBI has been reinforced by current politicians in office who anticipate a greater downfall in terms of losing their position in an election, thus, they tend to delegate authority to central bank in order to constrain the future government, that is restrict the range of policy actions available. Similarly, according to findings of (Cukierman, 1992) “Influence of Political Stability” countries experiencing political stability leads to a more independent central bank. The results showed that political parties' instabilities have a positive relation with CBI, whereas a high level political party instability has a negative relationship with CBI. The political arena is of greater importance in arriving to the conclusion as to why most countries experiencing high bout of inflation tend to be characterized by high level of political instability. The main contribution is to examine whether the political institutions have embarked on strengthening and supporting the democratic space in terms of political participation, democracy, accountability and openness in government.
2.6 Fiscal Positions
This paper will focus more specifically on various institutional arrangements focusing primarily on the central bank autonomy, financial institutions, fiscal position, political institutions and also macro-economic variables. In order to underscore the effect of ITF, it is also important to note that, most of the emerging economies that have already anchored their monetary strategy using this framework have a very short experience with regard to its implementation; therefore, the analysis will focus on those countries with more than two years of operation by the end of 2009. Similarly, since the data used in these paper is largely secondary data it varies greatly due to various factors associated to country specific, for example, political upheavals that may have derailed data collection; re-organization of governments from former regimes these is mainly related to former soviet union countries which disintegrated in 1990's.
3.1 Data coverage and sources
The Panel dataset covers thirty-nine developed economies, emerging markets and developing economies comprising of those markets that have targeted their monetary policy and those that are yet to target for the period ranging from 1980-2009. This is because it is easier to establish the effectiveness of the framework since the first country anchored its monetary policy in late 1980's.
<See appendix for further variable specific description>
3.2 Variable Specification
3.2.1 Exogenous variable
This paper is built on a “half year rule” in deciding the actual date that the inflation targeting countries adopted the framework. Therefore, the first six months of the year will be taken as the actual year of adoption and the second six months of the year will be captured in the year that follows and will be recognized as the year of inflation targeting adoption.
3.2.2 Endogenous Variables
I. Institutional Indicators
Institutional indicators have been highly used by various scholars and countries targeting inflation in determining the preference or probability of shifting their former monetary stance to inflation targeting framework. The variables of importance will be categorized into four broad indicators each proxied with variable of interest to be analyzed at a later stage.
Central Bank Independence Index proxied by both legal independence index and governor's turnover rate forms the first institutional indicator of interest. This paper is built on the indices of Cukierman et al (1992); Crowe, C. and Ellen E. Meade (2007); Kuttner and Posen (2001); Grilli, et al (GMT)(1992) it will take a diferent appraoch. I use their more or less methodology of arriving at the legal independence index by constructing a dummy variable of CBI guided by the following six broad questions: first, what is the authority primary objective of monetary policy conduct? Second, who is responsible in the appointment procedures of the chief executive of the authority? Third,
The Turnover rate of the Governors forms an inverse relationship of central bank autonomy where it is assumed that a high turnover rate is good indicator of fragile central bank sovereignty. Therefore, Cukierman et al (1992) derivation of the TOR will form the focal point of this paper and the expected sign is negatively related to the likelihood of adopting ITF.
Political stability variable forms a larger part in determining the probability of countries anchoring their inflation rate, in particular, the developing countries where democracy is highly undermined by few political elite. Beck et al (2001) constructed a dataset called Polity IV project to measure institutional political stability using databases of DPI. However, the Polity IV project is further reconstructed to Polity2 Index. Similarly, the focus is democratic score and autocratic score used to derive this index by deducting both score. Hence for the sake of this paper, a democratic score dummy will be indicated by 1 if a country is more democratic or zero otherwise. The same applies to autocratic score dummy where it will take a value of 1 if a country is very autocratic or zero otherwise.
The exchange rate regime forms the third institutional indicator variable. Many proponent of international finance have classified exchange rate regime into both “de jure” exchange rate(according to law), which basically captures central bank's official commitment to policy, however, it lack proper mechanism for actual policy control. The other classification of exchange rate regime is the “de facto” exchange rate (by existence) and it monitors the exchange rate movement, however, it lacks the intended compositional characteristics. The IMF's AnnualReport on Exchange Arrangement and Exchange Restrictions classified the exchange rate regime into nine categories and further re-classified the same into three folds namely: 1)floating exchange rate comprised of free floating, managed floating. 2) An intermediate floating comprising of basket pegging, crawling pegging and band arrangement 3) fixed exchange rate comprised of hard pegging and currency board.
For the purpose of this paper, I will employ the “de jure” exchange rate classification where I will construct a dummy variable, which will take the value of 1 if a country is under floating exchange rate or zero otherwise. Since the interest is built on the impact of the exchange rate regime towards country specific shifting to another monetary policy strategy. The sign of coefficient is expected to be positive, that is, the more flexible exchange rates the higher the chances of a country to adopt the framework.
II. Macro-economic Structure variables
The Financial Development variable forms the first macro-economic structural indicator of in interest. Therefore, it is of great importance to countries forging the way forward in case of adopting this strategy since it gives authority credibility to meet their intended objectives. Although, there are many indicators that have been used to test financial depth of various countries private credit ratio to GDP will form my indicator. I expect a positive coefficient that categorically states that, strong financial depth provides high probability of countries adopting this framework.
Second, trade openness which is the ratio of exports plus imports of goods and services to nominal GDP is used as an alternative to evaluate the extent of exposure to external shocks. This is because it has a direct relationship with the exchange rate regime hence a fixed exchange rate makes a country to be vulnerable to external shocks due to pressure of sustaining such regime. This variable has a positive relationship with the likelihood of adopting inflation targeting.
Third, Financial openness proxied by the ratio of external government debt to nominal GDP measures the financial openness of a country. Countries characterized with greater financial openness compel authority responsible of conducting monetary policy to inauspicious environment in the conduct of their business. Therefore, financial openness has an inverse relationship with the discretion of adopting inflation targeting framework.
The fourth measure of macroeconomic structure is fiscal balancewhich is typified by two aspects, that is,government balance to GDP ratio and current account to nominal GDP ratios.
The presumption is that, those countries that are highly characterized by government fiscal imbalances are conceived to command low levels of reliability. The variables in consideration are supposed to be positively related with ITF.
III. Control variables:
Third macroeconomic variable to be included in the model will be the log of GDP per capita (ln_GDP), which measures the variation in the level of economic development involving countries. Has a positive sign of coefficient to inflation targeting. Fourth Variable is the nominalized inflation rate (INF_N) hence the sign is expected to be negative. A normalized inflation is important in case of controlling weight of hyperinflation and it should be lagged two periods to avoid a potential simultaneity between inflation targeting and inflation level.
This paper aim at protracting logit model estimation in order to arrive at the choices facing various countries in particular developing countries in adopting inflation targeting. Moreover, the will
3.1.1 Panel data logit regression model
Due to the nature of the exogenous variable (I.e. binary exogenous variable) given as ITit where it takes a value of 1 if a country specific is inflation targeting and 0 otherwise. Subscripts i=1…N is the cross section dimension; t=1…T both representing country specific and years respectively. αit is the constant term. The white noise term is specified as μit=δit+ηit where δit designate unnoticed country-specific effects, whereas ηit is the random error. ηit ~ IN(0, ση2) is an assumption of random effects logit model specification.
IT it-2= αit + β INSTit + γ INF (-2)it+ υXit + μit ηit ~ IN(0, ση2)
The independent variables include institutional framework denoted as (INSTit) and comprises of various institutional variables comprised of: first, Central Bank Independence indices measured in this analysis by the turnover rate of central bank governors and legal independence of central banks'.
3.1.2 The Inflation approach
These section is built on both panel and cross-sectional approach, where the exogenous variable is nominal inflation rate variable. The independent variables arises from control variables comprised of trade openness, Log of GDP per Capita, dummy Exchange rate regime, proxy of current account to GDP ratio, and Polity2 index as a proxy of political instability. Under this section the variables under consideration will be grouped in three periods 1980-89, 1990-99 and 2000-2009, each is made up of at least ten years. I also include a dummy Inflation Targeting Framework (ITFt-2) in lag of two years in order to capture the marginal effect of the framework towards inflation rate for inflation targeting countries or zero otherwise.
<See Appendix VI, Table6 for further variable specific explanations>
The sample of IT countries is composed of Australia, Brazil, Colombia, Canada, Czech Republic, Chile, Guatemala, Ghana, Hungary, Israel, Mexico, Peru, Philippines, Poland, S. Africa, S. Korea, Thailand, Finland, Norway, Spain, Sweden, New Zealand, Iceland, and United Kingdom. Whereas, Non-IT countries includes: Bulgaria, Belgium, Egypt, Nigeria, Kenya, Dominic Republic, Ireland, Argentina, Morocco, Cape Verde, Equatorial Guinea, Honduras, Luxembourg, Netherlands ,and Greece. Difference in majority of literature on the actual dates and number of countries that have so far adopted ITF (eg Kuttner and Posen 2001) Peru IT regime to January 1993 vis a vis (Mish kin and Schmidt-Hebbel 2001) and Bank of Peru date it to January 1994 and January 2002). This paper will stress the (Levya 2008) countries IT classification by the end of 2005 exclusive of Ghana which adopted ITF in 2007 and Turkey (2006).
3.4 Estimating Results
The main analysis of this study will exhaust major avenues that have led many countries shifting their former monetary strategy to inflation targeting framework paying attention to emerging markets and developing countries. Factors such as institutional arrangement and macroeconomic variables that have been considered in this paper have a high likelihood of country's decision to embrace the ITF. The findings of my analysis using probit regression model have indicated that CBI has a positive relationship of a country specific adopting the framework this clearly states the need of major central bank to be fully independent before they embrace the framework. Similarly, market capitalization is one of the indicators of financial development of a country hence it is clear that, countries need to have strong financial institutions before switching to this framework. The Log of Real GDP per capita is significantly associated with the choice of inflation targeting hence a good precedent of improving overall economic performance; it is also consistent with the fact that the rationale behind adopting ITF is to improve economic performance.
The regressions results also indicate that majority of countries with floating exchange rate stand a high probability of embracing ITF. (Hu, 2003), found the negative effect of inflation over the chances of adopting the ITF be unforeseen, which is consistent with this analysis. “In fear of losing public credibility, the central bank is more likely to adopt inflation targeting when inflation rates are low, which makes the targeted inflation rate easier to achieve.” This is because most central banks are unwillingly to adopt inflation targeting during high bout of inflation that might undermine their credibility. Strong financial development variables are found to play a key role in determining the likelihood of developing countries adopting ITF under various regression specifications.
4.1 Policy Recommendation
Inflation targeting offers a coherent framework for the conduct of monetary policy, not only for industrialized and established emerging market economies but also, with some modification, for pre-emerging market economies such as Kenya with the dominant view that the basic architecture of the formal inflation-target framework is sound and is likely to remain in place in the future. The instruments independence, in which the central bank controls monetary policy instruments, should be insulated from short-run political pressures that may lead it to time-inconsistency trap thus producing bad long-run outcomes. In addition, the central bank's long-run preferences should coincide with society's preferences that suggest a goal dependent central bank, and a transparency of policy associated with inflation-targeting that is intended to central bank highly accountable to the public.
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