Policy transmission weak in Caucasus and central Asia – IMF

Structural weaknesses and limited operational independence impede monetary policy transmission in the Caucasus and central Asia, according to the International Monetary Fund. 

“The transmission from policy instruments to output is insignificant,” researchers say in a departmental paper published on August 30. “The transmission from the interest rate to inflation is short-lived.”

The paper explores the region’s policy frameworks and recommends improvements. Some countries need to do more to protect central banks’ independence, the researchers say. “Efforts need to focus on ensuring that the majority of board directors are non-executive and setting stricter rules for subsidised lending and other quasi-fiscal mandates.”

Inflation in the region is estimated to have peaked in early 2023 but still exceeds central bank targets. “The 2022 surge in international food and energy prices – with persistent supply-chain bottlenecks – underscored the region’s vulnerability,” the researchers write. 

Central banks in the region use a variety of policy frameworks. Armenia, Georgia, Kazakhstan, Kyrgyzstan and Uzbekistan are transitioning to inflation-targeting regimes. The central banks of Azerbaijan, Tajikistan and Turkmenistan rely on the exchange rate as an operational target, but have inflation targets and a legal mandate to ensure price stability.

Available monetary policy tools include setting policy rates, building excess reserves and conducting FX interventions. Transmission can be through setting the interest rate and bank lending, as well as balance sheet, asset price, exchange rate and expectations channels. 

Impediments to transmission include high dollarisation, small and illiquid capital markets, weak bank competition, limited cross-border capital mobility, and the absence of a well-established benchmark yield curve. The IMF paper adds there is often a “fear of floating”, which limits the ability of the exchange rate to absorb shocks. Supply-side shocks remain a major driver of inflation. 

In practice, the exchange rate plays a greater role than other channels on inflation, the researchers find. This is due to the high import content of the consumption basket and “balance sheet mismatches”, which means volatility in the exchange rate has a direct impact. 

Strengthening traditional monetary policy transmission channels will require developing financial markets, deepening financial inclusion and reducing dollarisation, the researchers recommend. Armenia, Georgia, Kazakhstan, Kyrgyzstan and Tajikistan have dedollarisation policies in place, while Azerbaijan and Uzbekistan do not.

There is also “scope to strengthen the operational framework by improving liquidity forecasting, co-ordinating better cashflow projections with the government, removing interest rate caps for policy instruments, and introducing intraday and overdraft credit facilities”, the IMF paper says. 

“Importantly, central banks alone cannot address deficiencies” associated with the economy’s institutions and structural characteristics, the researchers say. Central banks’ efforts “should be co-ordinated with, and complemented by, other government policies”.