Linah K Mohohlo: 2004 Monetary Policy Statement
Statement by Ms Linah K Mohohlo, Governor of the Bank of Botswana, Gaborone, 17 February 2004.
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Introduction
The 2004 Monetary Policy Statement I am presenting to you tonight is the sixth in a series issued on
an annual basis by the Bank of Botswana. The Statement and its mid-year review play a central role in
the Bank's efforts to convey to stakeholders and the public at large information on inflation and
monetary developments. The Statement also presents an opportunity for the Bank to outline in detail
the monetary policy framework, to communicate the annual objective for inflation, and to state the
approach that will be taken in formulating the Bank's response to inflation-related developments, so as
to ensure that the inflation objective will be met.
In this respect, the Monetary Policy Statement provides an opportunity for the Bank to be transparent,
with a view to influence economic and financial expectations of economic agents. The Bank aims
specifically to engender an expectation of low and stable inflation, consistent with the broad objective
of macroeconomic balance as a basis for sustainable growth in the country.
In line with past practice in delivering the Monetary Policy Statement, I will present only the main
highlights, and ask that you find time to read the full Statement, copies of which will be provided
shortly, in order to derive its full benefit.
I will begin by briefly reviewing current trends in inflation and their underlying causes, before assessing
the extent to which monetary policy succeeded in achieving related objectives in 2003. I will then
present the Bank's analysis of the economic and financial factors likely to have a bearing on inflation in
Botswana through the year ahead, as a basis for the policy outlook.
The Bank's monetary policy framework and objectives
For a start, I wish to remind you of the Bank's policy objectives and the framework in which they are
formulated and pursued. The principal objective of monetary policy in Botswana is the control of
inflation, as it is for most central banks. Specifically, it is the achievement of a sustainable low and
predictable level of inflation. Precisely how low inflation should be is a matter for debate; what is not
debatable (you will concur) is that we have not yet achieved the goal in Botswana. Be that as it may,
achieving domestic price stability is not just an end in itself; it is also the means by which the Bank
contributes, along with other government policies, to the fundamental objectives of a stable
macroeconomic environment and rising incomes and living standards for Botswana.
It is important to point out that this task is not pursued in isolation; it is aimed at supporting other
national objectives, such as economic diversification. In broad terms, this means being mindful of the
needs of both savers and investors when pursuing the inflation objective, by setting domestic interest
rates high enough to provide a positive return to savers but not so high that they discourage private
sector investment. It also means taking account of expected inflationary developments in trading
partner countries in setting the annual inflation objectives, such that monetary policy will contribute,
along with other policies, to maintaining Botswana's international competitiveness. The Bank can do
this by seeking to achieve, at a minimum, a rate of inflation that is no higher than the average inflation
rate of the major trading partner countries.
Given that the Bank's primary concern is controlling inflation, it is important that the sources of change
in the rate of inflation are examined closely, so that the Bank responds only to those changes that are
due to domestic demand pressures, and not those that may be due to transitory factors or supply
fluctuations over which monetary policy has little or no direct influence. Hence, in addition to the
inflation data published by the Central Statistics Office, the Bank examines measures of the underlying
inflation trend (core inflation), which exclude the impact of transitory factors and exceptional changes
in administered prices or indirect taxes. This is not to suggest that these price developments are
ignored. The Bank recognises the need to be prepared to respond, if necessary, to any impact these
items might have on underlying inflation through inflation expectations and second-round effects.
Other indicators of progress in meeting the inflation objective include the rate of growth of commercial
bank credit to the private sector and changes in government spending. Commercial bank credit is
monitored because it is an important contributor to the growth of private consumption and investment
and can be directly influenced by monetary policy through interest rates. Government spending is
important for monetary policy because of its large contribution to overall domestic demand. It is this
continuing large role of the Government in the economy that underscores the need for
complementarity between fiscal and monetary policies in achieving the inflation objective.
Domestic inflation trends in 2003
Let me briefly review monetary policy developments and actions undertaken last year, and share with
you what the Bank believes is possible for 2004. This will include a comment on the monetary policy
implications of the actual and potential developments.
You will recall that in the context of its longer-term objective of low and stable inflation, the Bank's
inflation objective for 2003 was 4 - 6 percent. Through this objective, the Bank sought to influence and
maintain expectations of sustainable low inflation in an environment of a high risk of a VAT-induced
increase in inflationary expectations. Moreover, the Bank considered that aiming for an inflation level
lower than what was expected in trading partner countries would help regain some of the
competitiveness that was lost in 2002 as a result of higher relative inflation in Botswana.
The external environment was generally supportive of these efforts. Imported inflation fell as global
inflation stayed low, while in South Africa inflation declined. Here at home, domestic demand
pressures eased as the earlier high rates of credit growth came down and the growth in government
expenditure was contained. The combination of low global inflation and reduced domestic demand
pressures led to a lower rate of inflation in Botswana as the year progressed, most notably from July
onwards, once the effect of VAT on inflation had run its course and began to drop out of the inflation
calculation.
VAT had a major impact in the initial 2 - 3 months following its introduction in July 2002. By the end of
that year, inflation had risen from the annual rate of 6 percent, where it had been in the months prior to
the introduction of the tax, to just over 11 percent. It rose further in the first half of 2003, peaking at an
annual rate of 12.2 percent in June; inflation then began to decline as the effect of VAT waned, and
demand pressures eased. By December 2003, inflation was almost back to pre-VAT levels, at
6.4 percent - just above the upper end of the Bank's inflation objective of 6 percent. When the impact
of VAT is discounted, which the Bank has estimated increased consumer prices by 4 to 5 percent,
underlying inflation was slightly above the upper end of the inflation objective for most of 2003.
Monetary policy implementation during 2003
While a major concern for monetary policy in 2003 was to contain the inflationary impact of the
introduction of VAT, it was also important that policy continued as much as possible to support the
downward trend in underlying inflation that had begun to develop in 2000 and 2001. In the
circumstances, monetary policy remained relatively restrictive for much of the year. However, as credit
growth slowed and inflation rates declined, as had been expected, and the global inflation outlook
remained supportive of continuing low inflation abroad, the Bank took the opportunity to reduce its
lending rate (Bank Rate) twice, by 50 basis points in October and by another 50 basis points in
December, taking it to 14.25 percent.
These reductions in the Bank Rate were followed by reductions in commercial bank lending and
deposit interest rates. Indeed the prime lending rate was reduced in two steps by a full one percentage
point to 15.75 percent, to match the reduction in the Bank Rate. Deposit interest rates, on the other
hand, were reduced by a lesser amount; for instance, the average 88-day deposit rate fell by 65 basis
points to 9.5 percent.
Despite this decline in domestic short-term nominal interest rates, inflation-adjusted (or real) interest
rates remained high as inflation declined. By year-end, the real three-month Bank of Botswana
Certificate (BoBC) middle rate was 6 percent, and higher than comparable rates in major economies
and in South Africa.
The Bank's operations in the money market were conducted during the year to ensure that short-term
interest rates, in particular the yield on three-month BoBCs, were consistent with this policy stance.
Market operations were also used to sterilise the large increase in liquidity arising from the continued
funding by the Government of the Public Officers Pension Fund. However, the growth in outstanding
BoBCs slowed towards the end of 2003, as an increasing volume of funds shifted to government
bonds and to offshore markets.
As most of you will know, P2.5 billion worth of government bonds were issued in 2003 with maturities
of 2 years, 5 years and 12 years. By the end of the year, the resulting yield curve was downward
sloping and all yields had fallen, which was an indication that the market expected that a decrease in
inflation would increase the possibility of a further easing of monetary policy.
I have already noted (with some satisfaction, I must say) that inflation in Botswana had fallen by
year-end to levels close to the upper end of the Bank's desired range. Inflation in trading partner
countries had also declined, even well beyond levels that had been expected earlier in the year. By
December 2003, average inflation in trading partner countries was more than 2 percentage points
lower than the earlier estimates of between 5.5 percent and 6 percent. As a result, the relatively high
inflation in Botswana, compared to that of trading partner countries, meant that there was a further
increase through the year in the real effective exchange rate, a development that raised concern that it
was contributing to a deterioration of Botswana's international competitiveness and, in turn,
undermining diversification efforts.
This is a valid concern, because it is important that Botswana continues to pursue a development
policy aimed at diversifying the economy away from its current dependence on relatively few products,
especially diamonds. Of course, there are different ways of achieving this policy goal, and while an
exchange rate strategy aimed at real exchange rate stability and international competitiveness can be
part of whatever approach is taken, it is important not to lose sight of the fact that real and durable
competitiveness and diversification must ultimately come from improvements in productivity.
It is in this context that, earlier this month, the Government took the decision to devalue the Pula by
7.5 percent against the basket of currencies to which it is pegged (South African rand, US dollar,
Japanese yen, UK pound sterling and euro). For its part, the Bank will continue to pursue a monetary
policy that complements this development and I will highlight in a moment the detail of what this
means for the Bank's policy stance for 2004. I hasten to emphasise at this point that the most
sustainable way to achieve and maintain a competitive real exchange rate is through the maintenance
of low and stable inflation, and the Bank's focus on bringing inflation down to low and sustainable
levels reflects both the national objective of export-led economic growth and diversification, as well as
the Bank's own statutory objective of achieving and maintaining monetary stability.
The outlook for inflation in 2004
Looking ahead, global economic recovery is expected to gather momentum in 2004, with current
estimates of world GDP growth moving up to around 4 percent and higher, compared to an estimated
range of 2.5 - 2.75 percent for 2003. Global inflation, however, is expected to remain low and may
even decline further in the face of continuing excess capacity in major industrial economies. Although
oil prices continue to be volatile, they are currently not expected to move much outside OPEC's target
price range.
Inflation in South Africa, which is the most important external influence on inflation in Botswana,
declined sharply in 2003, with the South African Reserve Bank's target measure of inflation (CPIX)
falling within the 3 - 6 percent target for the first time since its inception in 2000. It is expected that
inflation in South Africa will remain within the target range for most of 2004 in response to low
international inflation and the strength of the rand, although it is uncertain whether the appreciation of
the rand that has taken place recently will be sustained in 2004.
Despite this relatively supportive external environment, it is a fact that Botswana's import prices will
rise because of the recent devaluation of the Pula. The timing and extent of the rise will depend on
how much and how quickly importers adjust to the higher costs of their products. On the basis of the
proportion of imports in the consumer price index, it is estimated that higher import costs could directly
add up to 4 percentage points to inflation over the next 6-12 months, in the absence of any offsetting
declines in inflation elsewhere in the economy. There is also a danger that traders could exploit the
devaluation by raising prices across a range of goods and services by more than is justified by the
change in import costs, although this will be constrained to the extent that competition is effective.
Against this background, prospects are mixed. Domestic demand pressures, as indicated by the
growth of commercial bank credit and government expenditure, were lower in 2003, and the budget for
the 2004/05 fiscal year projects a welcome further reduction in spending growth. It remains to be seen,
however, whether this will be sufficient to offset the demand effects of the pickup in credit growth likely
to result from the 15 percent average wage increase for the public sector, which may spread to the
broader economy as private businesses concomitantly adjust their wage levels. Another risk to the
outlook for domestic inflation is the stronger expectations of higher future inflation that the devaluation
will engender. However, this year's increases in administered prices are not expected to exceed
average underlying inflation and this should mitigate the impact on the overall price level.
In the circumstances, it is possible that, despite the effects of the devaluation on imported inflation, the
more positive environment I have noted will prevail during the first half of the year, thus offsetting the
initial inflationary impact of the devaluation. Beyond this period, the balance of risks is much less
favourable. While the global impact on domestic prices is likely to be benign, the impact of the
devaluation on import prices will feed through to prices of domestically produced goods and services.
Furthermore, there is uncertainty with respect to the value of the rand, a depreciation of which may
lead to an increase in inflation regionally. Domestically, acceleration in the rate of credit growth outside
the range consistent with the Bank's inflation objective is likely, given the imminent increase in civil
service salaries and a consequent similar action by the private sector. However, the impact of the
likely credit expansion on domestic demand will be mitigated to some extent if the rate of growth of
government expenditure does not increase by more than the forecast 5 - 6 percent contained in the
2004/05 fiscal year budget, and businesses take measures to offset any possible wage rises.
Monetary policy stance in 2004
All of these factors must be considered when setting the monetary policy objective for 2004.
Importantly, in order to achieve a level of inflation that will contribute to maintaining relative stability in
the real effective exchange rate, the objective for the year must reflect expectations of inflation for
trading partner countries. The forecast inflation for these countries this year is lower than the 2003
estimate that was used to establish last year's inflation objective of 4 - 6 percent. This implies a need
for the Bank to lower its 2004 inflation objective in order to meet the goal of a stable real effective
exchange rate. You will agree that it would be unrealistic and costly, in terms of output and
employment, for the Bank to try and counter the full inflationary fall-out of the devaluation completely
over too short a period of time. It will be necessary, as a result, to accept some of the direct rise in
inflation from higher import costs, while focusing on preventing these costs from spilling into underlying
inflation and into inflation expectations.
To accommodate all these considerations, the Bank has concluded that an inflation objective of
4 - 7 percent during 2004 is appropriate. This will allow room and time for the economy to adjust to the
higher imported inflation arising from the devaluation, while ensuring that the potential gain in
competitiveness will not be eroded by higher inflation.
The widening of the range (in an upward direction) should not be seen as a loosening of monetary
policy. If anything, it implies the contrary, since it only allows overall inflation to rise by about
1 percentage point as a result of the recent devaluation of the Pula, notwithstanding the fact that
import prices are likely to rise by significantly more than this amount. The key task for monetary policy,
given this inflation objective, will be to prevent these import price increases from feeding through to the
prices of domestically produced goods and services. Inflation for these commodities will have to be
significantly lower than it would have been without the devaluation.
Without a relatively tight monetary policy stance, there is a real danger that inflation will rise, driven by
higher import prices and inflation expectations, to the point where the initial benefits to international
competitiveness resulting from the devaluation would be dissipated. It is essential that this is avoided if
the potential benefits of devaluation are to be realised. In this regard, it will help as well if other policies
that affect aggregate demand are tightened to help keep demand-related inflationary pressures in
check. As I have already noted, the Government's budget for 2004/05 goes some way in this direction
by limiting expenditure growth. Restraint by parastatals in raising their prices would further help
moderate inflationary pressures that arise from such administered price increases.
As I indicated earlier, the Bank's principal intermediate target is the rate of growth of bank credit to the
private sector, which is an important contributor to the growth of consumption and investment, and
hence to aggregate demand. A desired range for credit growth is specified in order to facilitate keeping
it at levels that are consistent with the Bank's inflation objective. The range for the growth rate of
commercial bank credit that is considered to be compatible with achieving the 2004 inflation objective
of 4 - 7 percent is 12 - 15 percent. This range is derived from the Bank's expectation of the rate of
growth of the non-mining sector of the economy (aggregate supply), and the desired inflation for the
year, with an allowance for the process of financial deepening as the economy develops.
Conclusion
I wish to conclude by underscoring the fact that this year's inflation target of 4 - 7 percent will prove to
be challenging. As you know, the path to price stability is neither smooth nor easy, and the Bank's
inflation objectives need to take this into account. The raising of the upper end of the range in 2004 is
a short-term tactical measure in response to a specific set of factors relating to inflation in 2004. The
expectation is that future inflation objectives will again relate directly to expected trading partner
inflation rates, in order to ensure real exchange rate stability and the Bank's longer term objective of
low and stable inflation.
Against the background of the recent devaluation, it will be difficult to ensure that the downward trend
in inflation that occurred in the second half of 2003 is sustained throughout 2004, but I can assure you
that the Bank will conduct monetary policy with the objective of ensuring that inflation falls within the
desired range of 4 - 7 percent by the end of 2004. The Bank remains committed to respond as
necessary and appropriately to monetary and inflation developments, in particular to any deviation of
credit and government spending growth from levels that are consistent with the inflation objective.
I thank you for both your patience and attention.