Monetary flexibility (monetary assessment). Overview: The unsuccessful recoveries in euro area is accounted for a large part of the crisis. The rebound that took place from 2009 to 2011 was derailed by the onset of the sovereign debt crisis. Although there was a nascent recovery starting in mid-2013, it also lost steam by the summer of 2014 as the external environment became more uncertain. The euro area economy, in other words, was consistently struggling to gain momentum and seemed highly vulnerable to further shocks. But things have also been clearly improving from mid-2014, monetary policy is one of the effective factors that can realistically explain the resilience of the recovery. The primary function of monetary policy is to support sustainable economic growth and attenuate major economic or financial shocks. It can be an important stabilization tool for sovereigns, helping ease credit conditions when economic growth is below potential and to tighten credit conditions when economy overheats. Therefore, a flexible monetary policy could be in significant importance in slowing or preventing deterioration of sovereign creditworthiness in times of stress. A sovereign monetary assessment results from the analysis of the following elements: 1.The exchange rate regime. 2.Monetary policy ‘s creditability 3.Monetary policy ͚s effectiveness Based on our criteria, we assign an assessment of ‘1’ corresponds to a sovereign with greatest monetary flexibility, where the monetary authority is able to control the interest rate and money supply to increase the lending and liquidity, in opposite, at times of overheating, the monetary authority is able to use monetary tools effectively, supported by a robust policy mix, to tighten credit conditions. This flexibility exists only for monetary authorities with high perceived policy credibility in countries with deep and diversified capital markets. On the other hand, we assign an assessment of “5” to a sovereign lacking monetary flexibility. Examples include: 1.Countries using a currency issued by another country; 2.Sovereigns that apply extensive exchange restrictions, or 3.Countries with persistently high inflation or high dollarization (defined as resident deposits or loans in foreign currency over 50% of total). A sovereign with these features either has very limited or no monetary flexibility to affect domestic economic conditions, including liquidity, or has a poor track record in meeting monetary objectives. If factors outside the control of the domestic monetary authorities mostly determine monetary conditions, there may be little buffer against domestic financial stress.
Exchange rate regime and monetary policy creditability and effectiveness: In the event that a sovereign can utilize monetary strategy to control the dominant currency used for domestic economic and financial market, it can address imbalance and shock in the domestic economy. The exchange rate regime influences the monetary authority’s ability to conduct monetary policy. Monetary objectives may struggle with goals to maintain a certain exchange rate level. The more unbending the exchange rate regime, the more likely this disconnect is to impede the conduct of monetary policy. Sovereigns with reserve currencies have the most flexibility. Such administrations are likely found in economies that are highly flexible and have significant net external asset positions. Therefore, for this kind of sovereign, we rank it at ͚1͛. Additionally, an powerful monetary policy requires credible institutions conducting it. Despite the fact “credibility” cannot be precisely measured, there are certain factors that generally make a central bank more trustworthy and, therefore, effective in its conduct of monetary policies. For instance, operational independence and management and legal independence, which allows the monetary authority to freely determine the best way of achieving policy goal. Effective monetary policy is important foundation for confidence in monetary authorities as well. In a period of stress, confidence is crucial because it allows policymakers to temporarily take unconventional means to deal with the impact of economic shocks. Monetary authorities with weak track records rarely have this flexibility. One of the main indicators of monetary policy effectiveness is broad price stability, including the low inflation rate over the economic cycle. The relationship between inflation and sovereign trading partners creates an important basis for confidence in local currencies as value storage and for the development of the financial sector. For sovereigns with the highest level of monetary flexibility, we expect asset prices to move in line with fundamentals. Regularly, when the output gap is small, we associate a credible monetary policy with a positive real interest rate. On the contrary, the continuing negative real interest rate cycle hinders savings, promotes borrowing, and generally reduces the confidence of money as a storage value. The operating losses that central banks incur are also regarded as damaging monetary effectiveness. Moreover, the ability of central government to issue a large amount of fixed interest rate local currency bonds is the key factors to assess the monetary policy effectiveness as well. The following two tables present the characteristics generally expected for each component of our monetary assessment. A sovereign’s initial assessment is derived by combining our assessments of the exchange rate regime and of the monetary policy credibility. In this combination, we assign a weight of 50% to credibility and monetary policy effectiveness and 50% to the exchange rate regime. The reason for this weighting is that both these two factors have profound effect on the economy. The initial assessment for sovereigns that is either part of a monetary union or not can be adjusted down by up to two categories based on the adjustment factors which we will discuss later. Exchange rate regime AssessmentOn a scale from ͚1͛ to ͚5͛, strongest to weakest1 Sovereigns with a reserve currency. A sovereign in this category benefits from a currency (which it controls) that accounts for more than 3% of the world’s total allocated foreign exchange reserves based on the IMF’s report “Currency Composition of Official Foreign Exchange Reserves. e.g. U.S.A2 Sovereigns with an actively traded currency.
A sovereign in this category benefits from a currency that is bought or sold in more than 1% of global foreign exchange market turnover, based on the Bank for International Settlement (BIS) report “Triennial Central Bank Survey,” that is not a reserve currency as defined above.3 Managed float. And intermittent intervention in foreign exchange market. e.g.: China4 Hard peg.5 No local currency.Adjustment for monetary assessment: An adjustment for sovereign’s monetary assessment results from the analysis of the following elements: 1.Negative adjustments to the initial monetary assessment Let us take more factors into consideration, for example, the sovereign has weak transmission mechanisms, which implies the county is not able to control the money supply in an effective way, thereby impeding monetary flexibility. The consequence could be sharply higher credit costs in the financial system, other unexpected losses by creditors in the financial system, or structural shifts in Monetary policy ‘s credibility and effectiveness Assessment On a scale from ͚1͛ to ͚5͛, strongest to weakest1 1. Strong and more than 10 years track record of full operational independence. 2. Clear monetary policy objectives. 3. Wide array of monetary instruments. 4. Ability to act as a lender of last resort for the financial system. 5. Sovereign’s CPI is low and in line with that of its trading partners, leading to stable REER over the economic cycle. 6. Broad price stability by other measures. 7. Depository corporation claims on residents in local currency and no sovereign bond market capitalization combined account for over 50% of GDP.2 1. Track record of operational independence.2. Market-based monetary instruments. 3. Ability to act as a lender of last resort for the financial system. 4. Sovereign’s CPI is low and broadly in line with that of its trading partners, leading to fairly stable REER over the economic cycle. 5. Broad price stability by other measures. 6. Depository corporation claims on residents in local currency and non-sovereign bond market capitalization combined account for over 50% of GDP.3 1. Operational independence, although shorter track record or less secure. 2. Market-based monetary instruments, but heavier reliance on reserve requirements. 3. Ability to act as a lender of last resort for the financial system. 4. Sovereign’s CPI is broadly in line with that of its trading partners over the economic cycle. 5. Depository corporation claims on residents in local currency. Non-sovereign bond market, and equity market capitalizations account in total for more than 50% DGP.4 1. Operational independence is limited by either lack of an effective transmission mechanism or perceived political interference. 2. Limited ability to act as a lender of last resort for the financial system. 3. Monetary statistics are not viewed as credible. 4. Average CPI typically exceeds 10%. 5 1. No ability to act as a lender of last resort for financial system.2. 5-year average CPI typically exceeds 20%.3. Sovereign government has US dollar demand exceeds 75%4. Sovereign government uses another country’s currency as its currency
the wholesale funding market. These risks can be further exacerbated if public financial and nonfinancial enterprises are dominant participants in the domestic capital markets. Furthermore, if foreign currency deposits are higher than 50%, it will increase vulnerability of a country to external and internal shocks and lack flexibility to adjust to these events. For instance, if a country hold 50% of dollar, and dollar become a mainstream currency in this country, think about what will happen if dollar depreciate? Can this country overcome this shock? 2.Sovereigns in monetary unions If we focus our credit rating in European countries, it is necessary to consider the influence of decision making by European central bank. The criteria of monetary union is firstly to take the whole zone into consideration and assigns an initial assessment. Then, it will lower some countries͛ rating regarding their economic situation. For example, Greece, the credit rating of Greece should be lower than the average level of whole European zone in the light of bad debt paying ability. 3. Restriction policy If the sovereign country imposes foreign exchange restriction on the payment and transfer of current international transactions, or implemented discriminatory monetary arrangement, the real monetary assessment result will be slightly lower than the initial assessment. 4. Countries using a currency issued by another countrySovereign government unilaterally uses another country’s currency as its currency. 5. High dollarizationSovereign government has US dollar demand exceeds 75% or savings dollarization. 6. High CPI or negative CPIThe 5-year average of CPI (previous year, this year, and three years in the future) is higher than 20% or the 5-year average of CPI is negative.