Can central bank’s monetary policy strengthen economic cycles in developing countries?

As shown in the Kazakhstan Economic Outlook (World Bank, Spring 2023), Kazakhstan's GDP increased by 3.2% in 2022, which is less than in 2021, when growth was 4.1%. It is noted that the decline in growth rates occurred mainly against the backdrop of a complicated geopolitical situation. At the same time, the slowdown in Kazakhstan’s economic growth occurred both on the demand side and on the supply side. Demand shocks include a decrease in investment activity and a decrease in consumer consumption as a result of a decrease in real incomes of the population. It is worth noting that it was the supply side that ensured economic growth in 2022 due to industrial production and services, although at a slower pace than in 2021. However, Russia's invasion of Ukraine affected the Kazakh economy largely through supply shocks. Since Russia is Kazakhstan’s largest import partner country, here can be highlighted a decrease in oil production, logistics problems, an increase in delays and costs when purchasing goods from Russia, disruptions in the operation of the Caspian Pipeline Consortium terminal, which led to a decrease in oil production.

As a result of the combined effect of supply and demand shocks, inflation in Kazakhstan reached historical highs, which led to a significant tightening of the monetary policy of the National Bank of the Republic of Kazakhstan (NB RK). However, the inflation rate in Kazakhstan, despite the permanent tightening of monetary policy, continued to grow during 2022 against the backdrop of rising global inflation.

Supply shocks are a problematic issue when implementing monetary policy in emerging economies such as Kazakhstan, as they give rise to the so-called developing country monetary policy dilemma. It is supply shocks that are associated with this dilemma, rather than demand shocks, since it is supply shocks that usually cause effects of the opposite sign on inflation and economic activity. The emerging market monetary policy dilemma is a situation in which the central bank, in response to temporary negative supply shocks, must choose between stimulating the economy and stabilizing inflation. If the central bank decides to reduce inflation, it will implement tight monetary policy, which may exacerbate the impact of the supply shock on economic activity. The monetary policy dilemma does not arise with demand shocks because in this case inflation and economic activity react in the same direction.

In particular, an analysis of temporary supply shocks is presented in an article by Colombian economists (José Antonio Ocampo, Jair Ojeda-Joya, 2022). The authors' research shows that in developing countries, monetary policy tends to be more pro-cyclical compared to developed country monetary policy after temporary supply shocks. The authors use data from 24 developing countries from 2004 to 2019 to estimate the impact of temporary negative supply shocks. In addition, the aim of the paper was to identify the determinants of the procyclical response of monetary policy in emerging market developing countries.

The authors obtained several results. First, the main result is that monetary policy implemented after temporary supply shocks in developing countries is largely pro-cyclical.

Second, the less flexible the exchange rate, the more pro-cyclical monetary policy will be. More flexible exchange rates allow for more independent monetary policy without necessarily imposing restrictions on international capital flows. A positive supply shock will strengthen the exchange rate, which will reduce inflation. The central bank needs to find a compromise between lower inflation and higher economic activity. A similar trade-off with opposite signs occurs in the case of a negative supply shock. If the economy operates under a floating exchange rate regime, the central bank may respond with countercyclical monetary policy to smooth out the impact on economic activity. However, if the exchange rate is fixed or not flexible enough, the central bank should use pro-cyclical monetary policy to stabilize the exchange rate. Therefore, to solve this monetary policy dilemma, the highest degree of exchange rate flexibility is important.

Third, monetary policy is more pro-cyclical in countries with higher degrees of financial openness. The latter result is a central dilemma for developing countries during supply shocks, since it implies that financial openness prevents less pro-cyclical monetary policy responses due to the trade-off between the exchange rate and income volatility. Developing countries with broad financial openness are more vulnerable to external shocks, resulting in a high degree of pass-through of external shocks to the real exchange rate, making monetary policy pro-cyclical. Thus, exchange rate flexibility is also particularly important if the economy has high financial openness, since such countries' exchange rates are more sensitive to supply shocks and the inflationary impact is more significant.

The conclusions about exchange rate flexibility are especially important for Kazakhstan, since, despite the fact that the official policy is pursued in which the tenge exchange rate is “free floating”, in reality NB RK actively participates in the foreign exchange market through foreign exchange interventions to reduce volatility and risks speculation at certain points. In addition, a feature of the economy of Kazakhstan is the formation of the republican budget using funds from the National Fund through transfers provided by NB RK. Officially, these transfers are not considered foreign exchange interventions, but to implement them, NB RK monthly converts dollar liquidity into tenge liquidity, which leads to an increase in the supply of foreign currency and a strengthening of the national currency exchange rate. However, given the high share of imported goods in the Kazakh economy, there is an increase in demand for foreign currency to pay for imports, which weakens the exchange rate of the national currency. Thus, there are various effects on the exchange rate in Kazakhstan, and the final result of its stabilization will depend on which of these effects is stronger.