III. Monetary Policy Transmission in Bolivia1
1. Although Bolivia has succeeded in achieving low single digit inflation, looking forward, it faces a number of challenges in the conduct of its monetary policy. Following hyperinflation in the mid 1980s, inflation was brought down from about 25 percent in the early 1990s to under 5 percent in recent years, with the crawling peg exchange rate regime playing a central role. Nonetheless, the central bank now faces new challenges, in particular those related to strong pressures for real exchange rate appreciation—and the associated inflationary effects—stemming from large current account inflows.
2. Managing emerging real exchange rate pressures to protect macroeconomic stability will require the central bank to use all its policy instruments, including greater exchange rate flexibility. Given the upward exchange rate pressures and government commitment to low inflation as a national asset, it is crucial to identify the links between monetary policy instruments and key economic variables to ensure that appropriate measures are taken in a forward looking manner. The preliminary analysis of the channels for the transmission of monetary policy in Bolivia is two-pronged. First, a qualitative assessment is provided of the effectiveness of individual channels for monetary policy transmission in the Bolivian economy. Second, a vector autoregression (VAR) model is used to assess the impact of shocks to monetary policy instruments—namely interest rates, exchange rate, and narrow money—on output and prices.
3. The analysis suggests the exchange rate channel has been the strongest for monetary policy transmission in Bolivia, partly on account of high dollarization, while other channels need to be strengthened. Prices are found to be affected mainly by the nominal effective exchange rate, while output is found to be influenced only by narrow money, though to a small degree. However, as more exchange rate flexibility is needed to effectively manage large current account inflows, the central bank will no longer be able to rely on the exchange rate to serve as the nominal anchor for the economy and will therefore need to enhance monetary policy transmission through other channels.
4. The chapter is organized as follows. Section B provides the institutional context and summarizes key monetary developments; section C discusses the channels for monetary transmission in Bolivia; section D presents the empirical analysis using a VAR model; and section E concludes.
B. Institutional Context and Key Monetary Trends
5. The main objective of the Central Bank of Bolivia (BCB) is to maintain low inflation, with secondary objectives of stabilizing the real effective exchange rate and the financial system. The exchange rate regime is based on a crawling peg, without a pre-announced path. Although the central bank has operational targets for reserve money and net international reserve accumulation, the exchange rate has been the de facto nominal anchor for the economy because of the crawling peg system.
6. The central bank has been successful in meeting its inflation objectives over the recent past, despite facing many difficult challenges. Inflation in Bolivia fell from about 25 percent at the beginning of the 1990s, to under 5 percent in recent years, with the exchange rate serving as an effective nominal anchor for the economy. This disinflation effort was achieved despite persistent fiscal deficits throughout the period (except for 2006), and several experiences of deposits runs in the financial system triggered by political instability—with the most significant drop in deposits taking place in 2002 and 2004.2 Over the period, the central bank made important efforts to safeguard the financial system, including through the accumulation of net international reserves (Figure 1).
Figure 1.Bolivia: Economic Developments, 1991-2006
1/ Real interest rate is calculated using the contemporaneous inflation rate.
Source: IFS, Central Bank of Bolivia, and Fund staff estimates.
7. High dollarization of the economy has been a serious constraint on the effectiveness of monetary policy. Between 1990 and 2003, foreign currency deposits averaged over 92 percent of total banking system deposits, while foreign currency credit averaged over 96 percent of total banking system credit (Figure 2). Though declining in recent years, this high level of dollarization has weakened monetary policy transmission in Bolivia, distorting the link between domestic money and inflation, increasing the vulnerability of the financial and corporate sectors to changes in the exchange rate, and altering impact of monetary policy actions.
Figure 2.Bolivia: Dollarization and External Developments, 2001-2006
Source: IFS, Central Bank of Bolivia, and Fund staff estimates.
8. Since 2003, Bolivia has benefited from a sharp turnaround in the balance of payments, leading to changes in the economic environment that will require adjustments to monetary policy to continue the success in containing inflation. Bolivia is experiencing large current account surpluses on the strength of mining and natural gas exports, which are generating strong real appreciation pressures on the local currency (Figure 2). In response, the central bank reversed the rate of crawl since mid-2005, allowing for a very modest nominal appreciation of the exchange rate. However, looking forward, a more flexible approach to exchange rate policy would be needed in order to manage these pressures and preserve macroeconomic stability.
C. Monetary Policy Transmission Channels
9. The monetary policy transmission mechanism comprises the ways in which monetary policy impacts aggregate demand and prices, by influencing investment and consumption decisions of firms, households, and financial intermediaries. The literature identifies five channels of monetary policy transmission3: (i) interest rate channel; (ii) bank lending channel; (iii) asset price channel; (iv) exchange rate channel; and (v) expectations channel.
10. Interest rate channel. The interest rate channel works through the effect of real interest rate developments on aggregate demand. Price rigidities allow nominal interest rate adjustments to produce corresponding real interest rate changes, altering the marginal cost of lending and borrowing, thereby impacting investment and spending. A key aspect of this channel is the extent to which a change in the central bank-controlled policy interest rate affects the term structure of interest rates (the yield curve). In Bolivia, there does appear to be a link between the policy rate and the domestic currency money market and deposit interest rates, and a weaker link with domestic currency lending rates (Figure 3). Nonetheless, the high level of foreign currency-denominated private sector credit substantially reduces the sensitivity of borrowers to domestic interest rate movements. Furthermore, in recent years, the cost of credit has tended to be a secondary issue for spending and investment decisions against the backdrop of a highly uncertain political environment.
Figure 3.Domestic Currency Interest Rates
Source: IFS, Central Bank of Bolivia, and Fund staff estimates.
11. Exchange rate channel. The exchange rate channel affects aggregate demand and prices through the pass-through effect, net exports, and firms’ balance sheets in the case of high dollarization. Generally, the larger the import share and the magnitude of a devaluation, the larger the pass-through effect on domestic prices. Exchange rate pass-through in Bolivia is expected to be significant due to the relatively high share of imports to GDP4 and, more importantly, because of the high dollarization of the economy. However, the impact of exchange rate depreciation on aggregate demand is uncertain as the possible expansionary effect of higher net exports (resulting from increased international competitiveness) could be offset by the negative balance sheet effects for unhedged borrowers.
12. Bank lending channel. The bank lending channel operates via the influence of monetary policy on the supply of bank loans, i.e., the quantity rather than the price of credit. A contractionary monetary shock reduces bank reserves and therefore the total amount of bank credit available, leading to a fall in consumption and investment. In Bolivia, monetary policy has a limited capacity to effectively control banks’ ability to supply loans. In the context of high dollarization, banks have the option of drawing on external assets and foreign credit lines in response to interest rate differentials between domestic and foreign dollar assets.
13. Asset price channel. The asset price channel operates by way of the monetary policy impact on the net wealth of economic agents. An expansionary monetary policy lowers interest rates and makes equity markets more attractive, thereby changing firms’ market value and household wealth. The former alters the relative price of new investment spending, while the latter affects household consumption and the availability of collateral borrowing. The asset price channel is unlikely to be important in Bolivia due to the underdevelopment of its capital markets and the limited private sector reliance on market financing. Transactions of stocks and private sector bonds amounted to US$200 million in 2006, representing only 10 percent of stock market transactions, which are dominated by trading of government paper.
14. Expectations channel. The expectations channel works through its impact on agents’ perceptions of the economic outlook. The basis for this channel is that variables that have an intertemporal dimension—and are therefore influenced by forward-looking considerations—are affected by agents’ beliefs about future shocks to the economy and how the central bank will react to them. In this way, the expectations channel shortens the reaction lag of the other transmission channels. Accordingly, the credibility of monetary policy is crucial to this transmission channel. In Bolivia, the expectations channel associated with the exchange rate played an important role in lowering inflation, due to its strong signaling effect on the economy. However, in a context in which the exchange rate could no longer serve as the nominal anchor, expectations would be determined by the central bank’s ability to continue to meet its inflation objectives.
D. Empirical Analysis
15. This section examines the empirical relationship between monetary policy variables and both output and prices. Based on a conventional vector autoregression (VAR) model, Granger causality tests and generalized impulse responses are used to provide some insight into the relative strengths of the most important transmission channels. The VAR approach places minimal restrictions on how monetary shocks affect the economy, explicitly recognizing the simultaneity between monetary policy and macroeconomic developments, as well as the dependence of economic variables on monetary policy.
16. The analysis considers the effects of three policy instruments—namely interest rates, exchange rate, and domestic narrow money—on output and prices. The policy interest rate chosen for the analysis is the 91-day bill rate, as it is the key short-term interest rate used by the BCB in its open market operations throughout the sample period. The nominal effective exchange rate (NEER) is used as opposed to the bilateral exchange rate against the U.S. dollar in order to better capture the authorities’ intention of adjusting the crawling peg to maintain competitiveness with respect to Bolivia’s main trading partners. Also, the NEER is preferred over the real effective exchange rate in order to better distinguish the exchange rate channel from other transmission channels. Domestic narrow money (M1) is used instead of broad money, as it is the monetary aggregate that the authorities can influence most directly. Output is measured as real GDP excluding mining and hydrocarbons, in order to focus on the sectors that can potentially be influenced by monetary policy.5 The consumer price index is taken as the measure of the general price level. All data series are in quarterly frequency and cover the period March 1990 to December 2006.6
17. The stationarity properties of the data were tested, and the lag length of the VAR estimation was selected using Akaike (AIC) and Schwartz (SC) information criteria. The Augmented Dickey-Fuller test indicates that the variables are I(1), suggesting the presence of unit roots. Nonetheless, the analysis was conducted in levels to allow for implicit cointegrating relationships in the data.7 Both the AIC and SC tests suggest a lag of the first order, and the Lagrange Multiplier test shows that the residuals are not serially correlated.
18. The multivariate Granger causality tests suggest the joint significance of the three policy variables for prices and output (Table 1). 8 The interest rate was found to have a significant Granger effect (at the 10 percent confidence level) on output and prices, which in itself would suggest that the traditional monetary transmission channel in Bolivia could be valid (however, as discussed below, this was not validated by the impulse responses). The nominal exchange rate has a significant Granger effect on prices but not output. This is consistent with the dollarization of the economy, as some pass-through of exchange rate changes to prices is expected, while the effect on aggregate demand is uncertain. Finally, narrow money was found to have a significant Granger effect on output but not on prices. This reflects the instability in the relationship between domestic money and prices caused by high dollarization.
|Effect on output|
|Block (p, x, s, M1)||0.01 ***|
|Interest rate (s)||0.09 *|
|Exchange rate (x)||0.67|
|Narrow money (M1)||0.02 **|
|Effect on prices|
|Block (p, x, s, M1)||0.00 ***|
|Interest rate (s)||0.08 *|
|Exchange rate (x)||0.03 **|
|Narrow money (M1)||0.58|
19. The VAR representation is given by:
where Yt is a vector of endogenous variables and Zt is a vector of exogenous variables. The vector of endogenous variables consists of real GDP excluding mining and hydrocarbons (yt), the consumer price index (pt), the 91-day bill rate (st), the nominal effective exchange rate (xt), and the monetary aggregate M1 (mt). The order of the variables reflects the likely degree of endogeneity of the policy variables to current economic conditions.9 The vector of exogenous variables consists of an index of world oil prices (oilpt), as a proxy for developments in the hydrocarbons sector, and the U.S. federal funds rate (stUS), to account for interest rate parity. In addition, a dummy variable was included to account for deposit withdrawals that Bolivia has encountered over the sample period, which have had a bearing on central bank policy decisions.
20. In general, the results from the impulse response functions point to the exchange rate as the most significant tool for monetary transmission in Bolivia. Figure 4 presents the impact on output and prices of a one-standard deviation shock to each policy-related variable. The estimated impacts of the interest rate on output and prices have the expected direction, but are not statistically significant, pointing to the weakness of the interest rate channel for monetary transmission in Bolivia. Meanwhile, the estimated effects of the exchange rate on output and prices are as anticipated. While the exchange rate was found not to have a significant impact on output, a depreciation of the exchange rate leads to an increase in prices that becomes significant after two quarters. Finally, a shock to M1 appears to have a significant effect on output but not on prices. Nonetheless, the impact on output is quite small, indicating the minor role that monetary policy can play in stimulating aggregate demand in Bolivia.
Figure 4.Impulse Responses to Basic Model
21. Adding the domestic currency lending rate to the VAR confirms the weakness of the interest rate channel in Bolivia. The basic VAR was extended by adding the lending rate in domestic currency, in order to examine the interest rate channel more closely. Granger causality was found to run from the policy rate to the lending rate, indicating some pass-through from policy to market interest rates (Table 2). However, output and prices do not respond significantly to lending rate shocks, again highlighting the weakness of the interest rate channel in Bolivia (Figure 5).
|91-day Bill Rate does not Granger Cause Lending Rate||3.69||0.05 **|
|Lending Rate does not Granger Cause 91-day Bill Rate||1.58||0.21|
|91-day Bill Rate does not Granger Cause Deposit Rate||16.46||0.00 ***|
|Deposit Rate does not Granger Cause 91-day Bill Rate||0.00||0.97|
|Deposit Rate does not Granger Cause Lending Rate||8.22||0.01 ***|
|Lending Rate does not Granger Cause Deposit Rate||0.18||0.67|Figure 5.Impulse Responses to Extended Models
22. Looking at the effects of credit to the private sector on prices suggests that the bank lending channel may be valid. In order to examine the role of bank lending in the transmission of monetary policy in Bolivia, credit to the private sector (domestic and foreign currency) was included in the basic VAR model. The results indicate that a shock to credit has an impact on prices, which becomes significant with one-quarter lag, although to a lesser extent than with an exchange rate shock (Figure 5). Innovations to credit do not yield a significant output response, which is consistent with the poor performance of private sector credit in recent years. After peaking at more than 50 percent of GDP in 2000, credit to the private sector fell to less than 35 percent of GDP in 2006, and currently accounts for only about 56 percent of total banking system assets.
E. Conclusions and Policy Implications
23. While the exchange rate has been found to be the strongest channel for monetary policy transmission in Bolivia, looking forward, the central bank will face the need to strengthen other channels. The empirical results indicate that prices have been affected mainly by the nominal effective exchange rate and to a much lesser extent by bank lending. Meanwhile, output was found to be affected only to a small degree by shocks to narrow money. In the short term, the real appreciation pressures would facilitate low inflation, to the extent that they are reflected in nominal exchange rate appreciation.
24. Over the medium term, additional measures would be needed in order to enhance the effectiveness of transmission channels, particularly in the event of a reversal of the appreciation trends. Key policy challenges will include deepening financial intermediation and fostering a continued reduction of dollarization. However, this may take time, therefore it will be essential to maintain financial policies consistent with external stability (thereby forestalling depreciation pressures), in particular a prudent fiscal stance.
- Export Citation
Égert, Balázs, andRonaldMacDonald,2006, “Monetary Transmission Mechanism in Transition Economies: Surveying the Surveyable,”CESifo Working Paper No. 1739 (June).
Loayza, Norman, andKlausSchmidt-Hebbel, eds.2002, Monetary Policy: Rules and Transmission Mechanisms (Santiago:Central Bank of Chile.)
Mishkin, Frederic,1996, “The Channels of Monetary Transmission: Lessons for Monetary Policy,”NBER Working Paper No. 5464 (February).
Mishkin, Frederic,2001, “The Transmission Mechanism and the Role of Asset Prices in Monetary Policy,”NBER Working Paper No. 8617 (December).
Sims,Christopher,JamesStock, andMarkWatson,1990, “Inference in Linear Time Series Models with Some Unit Roots,”Econometrica,Vol. 58 (January), pp. 113–144.
Prepared by Laura Jaramillo Mayor.
Between 1990 and 2006, there were 13 episodes of quarter on quarter decline in banking system deposits.
In 2006, imports of good and services in Bolivia amounted to 31 percent of GDP, compared to an average of 23 percent for Latin America and Caribbean region.
Investment and overall performance in the mining and hydrocarbons sectors in Bolivia is determined to large extent by international prices, taxation policy, and long-term bilateral agreements with trading partners.
Data series come from the IFS database and the Central Bank of Bolivia. All data are expressed in natural logs and are seasonally adjusted using ARIMA X12, with the exception of the interest rate.
Sims, Stock, and Watson (1990) show that an analysis in levels is valid if enough of the variables are cointegrated, because the ordinary least squares estimator of the reduced-form VAR efficiently estimates the cointegrating relationship.
These results should be interpreted with caution as they are sensitive to the choice of lag length. A high number of lags tends to reduce the significance of interest rate and exchange rate effects on prices.
Results are robust to alternative orderings of the variables.