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Monetary policy and economic stability in the Arab world

Commentary by Ghanie Ghaussy

Freedom and order for more justice: social market economy - a model for the Arab world?

This is the latest in a series of commentaries The Daily Star is publishing in association with the Konrad Adenauer Stiftung, a German research foundation.

The mission of monetary policy is to manage the policy related to money and to credit within a national economy. It relates more particularly to regulation by the Central Bank of the money stock, its primary objective being to guarantee monetary stability. The state, too, influences monetary policy, either directly or indirectly, via financial policy, exchange rates and foreign trade. In most Arab countries, this influence is often direct and considerable. The state does not only influence Central Bank decisions, but also intervenes directly - often for stability reasons - and via the financial and monetary policy, in the economic process. This intervention may also be justified by the fact that, within a national economy, the various economic objectives - growth, price stability and equilibrium of the balance of payments - cannot be achieved simultaneously but are partially opposed. Accordingly, while an increase in the money stock may stimulate growth, it is at the same a threat to price stability and the equilibrium of the balance of payments. Economists talk in this context of the "magic triangle" of monetary policy and stability.

Economic growth in Arab countries is subject to strong periodic variations. Between 1975 and 1982 and between 1985 and 1990, these countries reported high growth rates. Subsequently, and until 1995, the growth rates had been steadily on the decrease. As from 1996, the rates have once again stabilized at a fairly high level (around 5.6 percent on average). However, this growth did not benefit all Arab countries due to existing differences in terms of natural resources and monetary and tax policy in these different countries.

As regards monetary policy, it would be relevant to analyze the relationship between the money stock (M1) Money stock (M1): component currency, notes, demand deposits (subject to no term, means of payment always available). the quasi-money stock (M2) Money stock (M2): M1 + time deposits with a term of 4 years or less. And the price level (here: consumer price index - CPI), for it reflects the close relationship between the policy related to the money stock and the inflation rate. According to World Bank and IMF indications, relatively poor Arab countries, such as Egypt, Jordan, Lebanon Morocco, Syria and Yemen, have reported, for rather long periods, not only high growth rates of their M1 and M2 money stocks, but also relatively high prices. By contrast, oil-producing countries, such as Kuwait, Libya, Oman and Saudi Arabia, have reported fairly low growth rates of their M1 and M2 money stocks, together with fairly moderate price rises. These examples illustrate the direct relationship between monetary policy and inflation.

Central banks (banks of issue) are the main actors of national monetary policy. These institutions may, therefore, see to stability in matter of prices in Arab countries. They have multiple tools at their disposal. Among classical monetary policy measures, one may mention discount or refunding policy, minimum reserve policy and open market policy.

To these, one would add the currency-related policy which the state contributes in devising, and the direct credit restriction policy of the bank of issue.

The discount or refunding policy relates to variation of the discount rates by which commercial banks may, in case of need, obtain short-term credits from the Central Bank. The banks submit to the Central Bank discountable commercial paper (discount policy) or mortgage certificates of deposit (Lombard rate policy) in order to obtain short-term loans from the Central Bank. Based on variation of the discount or Lombard rates, the Central Bank may influence credit demand by banks and by the private sector. Conditions for such credits in the Arab world differ from one country to another. It is worth emphasizing that the policy related to the money stock, in this way, can only obtain in the presence of a well-developed capital market. Unlike Western industrialized countries, most Arab countries do not meet this requirement. Consequently, such monetary policy measures are less efficient in them.

The minimum reserve policy relates to variation of the deposits reserve rates (demand deposits and time deposits) which commercial banks must constitute with the Central Bank. An increase of the reserve rate narrows the room for maneuver of private banks, while a reduction of this rate increases the possibility of granting credit. This instrument, which is often used in industrialized countries, steers directly the money stock and, thus, influences demand for credit by the private sector. In Arab countries, this tool is hardly used due to lack of proper legislation.

In the case of an open market policy, the Central Bank buys or sells treasury notes or bonds, as well as local government treasury bonds, directly on the market and, thus, influences the money stock held by the private sector. This policy of steering the money supply, commonly used in the West, is limited to the Arab countries which resort to treasury notes and bonds negotiated via the banking system. It also requires private sector confidence in the state financial policy which, with very rare exceptions, does not obtain in the Arab world.

Finally, concerning the policy related to exchange rates; the Central Bank is not autonomous but operates in close cooperation with the state. Indeed, the purchase and sale of currencies on the spot market and the forward market do not only have direct effects on the money stock, but also influence foreign currency prices on the exchange market and national currency exchange rates. This measure is widely used in almost all Arab countries. However, we do no have precise statistical data as to the volume of these transactions in the various countries.

Now, there is yet one measure that is non-market-compliant, i.e. the direct credit policy of the bank of emission or of the state. In an inflationist economy where the measures outlined above do not have the expected effect, not only the state is led, in its deficit management policy, not to use up the credits allocated to it, but also the Central Bank and state-owned and private banks are forced not to exceed a certain credit ceiling. This highly constraining measure is very rarely used. The IMF recommends this measure only when trying to curb a rampant inflation rate of the kind Algeria experienced during the 1990s.

While resorting to these various monetary policy measures, it is important to take into consideration the fact that their impacts always obtain with a certain time lag. This is all the more true in Arab countries where the monetary market and the capital market are not quite developed yet. In the case of the smaller Arab countries, whose markets strongly depend on international markets (the Gulf countries, or Lebanon, for instance), the effects of the monetary policy of the bank of issue and of the stability policy of the state can, furthermore, be neutralized by external elements, of which financial flows to or from overseas, for instance. Besides, the success of monetary policy also depends on other measures of economic policy and, particularly, financial policy and foreign trade.

Ghanie Ghaussy is professor emeritus in political economy. He has taught since 1979 at Hemult Schmidt University/University of the German Army in Hamburg. Pr. Ghaussy is an eminent expert on Islam and an authority on social market economy.

Marseille,12 17 2007
The Daily Star
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