Monetary Policy Challenges March 2010 International Monetary Fund Nicholas Staines IMF, African Department

Objectives This presentation considers the implications and risks of the proposed new fiscal stance on monetary policy: The proposal to expand the use of domestic borrowing to finance investment. The Government’s intention to incur foreign non- concessional borrowing (NCB) to finance investment. The presentation assumes a temporary increase in NCB. 2

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Goals Primary goal The Bank of Mozambique’s (BM) monetary policy is primarily geared towards maintaining low inflation. Subordinate goals Maintaining external stability and adequate external reserves. Deepening financial intermediation, helping to route financial resources from savers to their best use and increasing private sector credit. 4

Implementation Policy implemented in reserve money targeting framework and in context of a flexible exchange rate, while smoothing seasonal and temporary imbalances. The BM sets monetary expansion in line with projected economic growth and the desired inflation rate. It stands ready to tighten monetary conditions to ward off inflation. The BM could soon be in a position to decide whether to move to an inflation targeting framework. 5

Achievements The Bank of Mozambique (BM) has generally met its goals: Inflation has trended down, despite difficulties in meeting money targets. Progress in deepening financial intermediation, measured by M2/GDP, has been slow. But private sector credit’s GDP share has increased since 2004, though the large increase in 2008/09 is probably temporary. Prudent policy provided scope to ease monetary conditions during the food/fuel price surge and the recent financial crisis. 6

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Domestic v Foreign Borrowing Additional investment increase aggregate demand. Using domestic borrowing, the Government competes with the private sector for productive resources. Unless growth is large enough, the private sector will be crowded out. Using foreign borrowing, the Government can make use of foreign productive resources without competing with the private sector. But this requires that those productive resources are imported. 8

Inflation - Impact Inflationary pressures from additional investment are expected to be limited. The investment could potentially boost domestic demand and fuel inflation. But this would be mitigated by import leakages that are likely to be high. Relative price pressures are likely to be stronger in certain areas, i.e. skilled labor and construction. The Government may consider easing restrictions on imported services. The increased productivity from investment would reduce price pressures over time. 9

Inflation – Policy The proposed change in fiscal policy stance could make the BM’s monetary policy implementation more difficult. As the primary goal is to contain inflation, the scope for the BM to accommodate additional demand is limited. Should domestic demand pressures materialize, the BM would need to tighten conditions, restricting private sector credit. Relative price changes should not to be confused with overall inflation. The BM could declare its commitment to keep inflation between 5 to 6 percent. 10

Investment Financed by Domestic Borrowing The Government’s avoidance of domestic borrowing has helped reduce inflation and made room for private sector credit. In view of the BM’s goal of keeping inflation low, the scope to expand monetary growth to accommodate domestic borrowing is limited. Government domestic borrowing, if too large, will therefore restrict room for private sector credit. The Government could declare its commitment to limit domestic financing. 11

Investment Financed by NCB A increase in NCB-financed investment would pose especially large policy challenges. The issues are similar to those with loan aid flows – but NCB is more expensive and poses greater risks. NCB flows should be used primarily for investment imports. (A portion should be saved for debt service). Otherwise, NCB flows could crowd out private spending or finance private imports (including consumer goods). 12

NCB and The Exchange Rate NCB inflows would initially appreciate the exchange rate and deteriorate the external current account (‘Dutch disease’). The appreciation would be higher if the capital inflows were spent domestically. The BM would need to sterilize the liquidity injected through domestic spending by selling reserves. It would be lower if the Government used the proceeds primarily to finance imports. This would reduce the need for the BM to sterilize liquidity. Appreciation pressures would be later offset by productivity gains from investment. The BM would subsequently need to sell reserves to pay external debt service or allow the exchange rate to depreciate and the non- interest external current deficit to contract. 13

NCB and External Reserves The BM should accumulate reserves for debt service payments. It would moderate exchange rate swings and support market confidence. But it would be expensive. It implies using costly NCB resources to invest in low-yielding foreign securities - not growth – and would require expensive sterilization with T-bills. The MF should reimburse the BM. Resources cannot be spent twice. Using the same portion of NCB resources for both investment and reserves is equivalent to public sector borrowing. It will therefore restrict private sector credit. The BM should not accumulate reserves to cover NCB-financed imports as these are financed and temporary. 14

NCB and Managing Liquidity Large NCB inflows will complicate liquidity management. Aid flows deposited by the Government with the BM are already the main source of liquidity (5-6 percent of GDP). The BM sterilizes the excess liquidity by selling foreign exchange reserve or T-bills. Routing large NCB proceeds through the BM would add significantly to the liquidity being injected and greatly complicate the challenges of liquidity management. The Government and the BM need to improve their coordination for managing liquidity. 15

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Conclusions The change in fiscal stance poses large monetary policy challenges. The BM needs to remain committed to maintaining low inflation. It should declare its commitment to keep inflation between 5 and 6 percent. Domestic Borrowing Financing investment with domestic borrowing could crowd out private sector credit as the BM has only limited scope for accommodation. A temporary increase in NCB Growth and stability would be enhanced if NCB resources were primarily used for investment imports. The BM should accumulate reserves to meet NCB debt service payments. The Government needs to remunerate the BM for the costs. The Government and BM need to improve their coordination for managing liquidity. 17

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