Monetary Policy, Central Banks’ Independence, and Financial Development in Africa

Abstract

There is a close relationship between monetary policy and financial development. Financial systems are essential to monetary policy as they act as conduits by which central bank policy tools are implemented. These tools are expected to influence financial market prices, reflecting market participants’ expectations about economic and monetary developments. Because monetary policy primarily works through expectations, its effectiveness is dependent on the transparency and credibility of the monetary policy framework. This is important because the evidence on monetary policy effectiveness has been largely inconclusive. There have been arguments that this could be conditioned on the independence of the central bank. We analyse the usefulness of central bank independence (CBI) in explaining the impact of monetary policy on banking sector and capital market development in Africa using Two-Stage GMM, Two-Stage Least Squares, and Fixed Effects estimation techniques, with data spanning 1970–2014 on 48 African countries. Using policy rate, money supply, and real interest rates as measures of monetary policy stance and CBI data from Garriga (2016) and Bodea and Hicks (2015), we find that monetary policy effectiveness on financial development is higher for the banking sector than for capital markets. Central bank independence has a significantly positive impact on both banking sector and capital market development. The effect of monetary policy on financial development is enhanced by CBI as the magnitude of its impact on financial is higher in the presence of higher levels of CBI in Africa. The policy implication for these findings is that monetary policy credibility is essential for financial development in Africa. This credibility could be found in making central banks in Africa independent of political control.

Appendix: Descriptive Statistics

Variable	Mean	Median	Max	Min	SD	Obs
Priv. Crt	19.892	14.736	160.125	0.491	19.347	1769
Dom. Crt	17. 345	12.289	158.093	0.4031	18.921	1769
Stock.MkCap	36.043	13.785	96.939	0.009	76.587	335
NIM	18.3410	16.432	41.220	8.229	24.133	1150
MPR	27.88	30.13	39.12	16.532	26.612	1123
RIR	9.28	10.25	15.23	6.87	5.63	1543
M2	30.02	17.365	67.84	27.54	16.43	1542
CBI	0.501	0.501	0.866	0.137	0.197	1593
PolInst	2.178	2	6	0	1.451	1986
FEXRT	0.311	0.302	1	0	0.454	1259
DEBTG	57.091	43.308	265.128	1.389	47.434	1114
GDPR	4.084	14.736	149.73	−62.08	7.682	1908
Per Capita GDP	1362.7	1568.5	14,749.2	113.7	2129.5	1429
POPUL (log)	5.241	7.736	26.73	2.118	3.37	2013
TRD.OPEN	43.58	45.2	92.9	22.5	16.5	1569
IT	0.019	0.018	1	0	0.0967	1588
FINOPEN	−0.25	−0.0.15	2.37	−1.90	1.45	1986
CBASSETS	2.21	2.35	3.56	1.25	1.451	1986

1. ${\mathrm{PRIV}.\mathrm{CRE}}_{\mathrm{it}}$ denotes the ratio of domestic private credit to GDP.${\mathrm{DOM}.\mathrm{CRE}}_{\mathrm{it}}$ is domestic credit to private sector which refers to financial resources provided to the private sector by banks.${\mathrm{STOCK}.\mathrm{MKCAP}}_{\mathrm{it}}$ denotes the ratio of stock market capitalisation to GDP.$\mathrm{NIM}$ denotes net interest margin$.\mathrm{ NOTES}: {\mathrm{PRIV}.\mathrm{CRT}}_{\mathrm{it}}$ denotes the ratio of domestic private credit to GDP. ${\mathrm{STOCK}.\mathrm{MKCAP}}_{\mathrm{it}}$ denotes the ratio of stock market capitalisation to GDP. ${\mathrm{CBI}}_{\mathrm{it}}$ is the central bank independence measured by the CWN index, ${\mathrm{GDPR}}_{\mathrm{it}}$ is the real GDP annual growth rate, ${\mathrm{LGDPC}}_{\mathrm{it}}$ is log of real GDP per capita, ${\mathrm{PolInstl}}_{\mathrm{it}}$ is the rescaled political rights score, from 0–6 where 0 denotes least respect for political rights and 6 highest respect for political rights, and $\mathrm{TRD}.\mathrm{OPEN}$ is the trade openness measured as the ratio of sum of exports and imports to GDP. ${\mathrm{FEXRT}}_{\mathrm{it}}$ is a dummy variable for the exchange rate regime measured as 1 for fixed exchange rate regimes and 0 otherwise.${\mathrm{IT}}_{\mathrm{it}}$ denotes inflation targeting regime and is a dummy measured as 1 for inflation targeting regimes and 0 otherwise.${\mathrm{POPUL}}_{\mathrm{it}}$ is the size of the population and ${\mathrm{DEBTG}}_{\mathrm{it}}$ is the debt to GDP ratio..${\mathrm{MPR}}_{\mathrm{it}}$ is the central bank policy rate. ${\mathrm{M}2}_{\mathrm{it}} is$ Money and quasi money and comprise the sum of currency outside banks, demand deposits other than those of the central government, and the time, savings, and foreign currency deposits of resident sectors other than the central government.${\mathrm{RIR}}_{\mathrm{it}}$ is real interest rates. ${\mathrm{CBASSETS}}_{\mathrm{it}}$ is the ratio of central bank assets to GDP and ${\mathrm{FINOPEN}}_{\mathrm{it}}$ is Chinn-Ito index for capital openness