Soon after its establishment in 1964, the National Bank of Rwanda (NBR) became responsible for organizing and supporting the realization of government social and economic policy. Thus, the conduct of monetary policy was subdued and subordinate to fiscal considerations. In this context the NBR devoted itself to direct monetary control, as was the case in almost all developing countries, thus maintaining the money supply at a level compatible with the government's macroeconomic objectives. Credit controls were achieved by rationing credit to commercial bank customers. Only after 1990 were commercial banks compelled to keep unused a certain fraction of the deposits of their customers, and the central bank sought to sterilize a part of bank resources usually used in making loans. Indeed, the fact of keeping required reserves at the NBR restricted credit expansion and consequently reduced monetary growth rates. Prior to reform, according to how the NBR saw the economic situation evolving, and taking into account the expected variation in banks' reserves, the central bank determined, annually, a total ceiling to the direct lending awarded to the commercial banks. Quotas, then, were established for each one of these institutions, corresponding to each bank's expected shortfall. The NBR had to determine at the end of each year, the limit of its funds that it would devote to commercial banks through rediscounts, during the following year. Furthermore, the central bank had to authorize any loan by a bank to customers exceeding a certain amount.
However, as in some other countries, direct monetary policy proved to be inefficient in Rwanda, and its prevalence led to disastrous consequences as resources were misallocated.
Inefficiency in financial intermediation meant lower savings, investment and economic growth.
Like a number of developing countries, Rwanda shifted from direct to indirect monetary policy starting in November 1990, as structural adjustments took effect. Indeed some changes were made in anticipation of these reforms. Direct control of prices and interest rates were gradually abandoned to allow for the determination of prices by market forces. Nevertheless, the efforts undertaken with structural reforms in order to reduce the role of the government in the economy were soon suspended following the war that degenerated into genocide in April 1994. These policies were reactivated in 1995 after the war and genocide, and the liberalization process made steady progress. In this new environment monetary policy come to rely more and more on indirect instruments.
In line with the Poverty Reduction and Growth Facilities (PRGF), which is currently being implemented, the Rwandan monetary authority in collaboration with the IMF and other donors, decided on a medium-term inflation target of three per cent a year. As inflation is a variable that the NBR cannot control directly, the central bank uses M2 as an intermediate instrument of control. The assumption being that if M2 is reduced, then inflation will fall. The next chapter examines to what extent this is possible. The monetary stock is changed by adjustments to the monetary base. The latter is selected as it is within the capacity of central bank control. The NBR bases its decision to change the monetary base both on long-term and short-term forecasts. Such forecasts enable the monetary authority to maintain monetary
balances at levels compatible with the real needs of the economy. Weekly liquidity forecasts, which are consistent with monthly forecasts and the annual monetary programme, now form the basis for the nature of open market operations carried out by the NBR.
In line with its current indirect monetary policy, the NBR uses effective monetary policy instruments in order to control commercial banks' free reserves to ensure that the supply of base money does not deviate from desired levels. These indirect monetary instruments are: (i) open-market type operations, (ii) the discount window, and (iii) reserve ratio requirements. In August 1997, a money market was established to ensure greater control on base money. A weekly auction of treasury bills establishes a market interest rate known as the Bank rate.
Treasury bills were introduced as a reform in order to limit the government monetising its debt that entailed fuelling inflationary pressures. The introduction of treasury bills was also meant to encourage private saving, although crowding out remains a possible problem. In addition, banks in need of liquidity can cover their shortages at the discount window of the NBR. An inter-bank money market has been operative in Rwanda since 2000, and banks can lend to one another, sometimes at rates below the Bank rate.
The effectiveness of the Rwandan indirect monetary policy has been undermined by a number of factors:
(i) Foreign currency flows are difficult to forecast and this affects all other forecasts, including base money that the NBR uses in its decision making. Money demand specifications should include exchange rate considerations. In the next chapter we estimate a money demand function without external links to establish a baseline
model. Future research would need to look at the impact of the foreign section on the baseline model,
(ii) It is difficult to forecast real GDP growth given the informal nature of the Rwandan economy. Thus money supply changes are based on incorrect suppositions as to the nature of macroeconomic conditions,
(iii) The Rwandan financial sector is still underdeveloped and financial markets do not have high trading volumes,
(iv) The Rwandan money market, operational since September 1997 is still evolving.
Only a few economic agents are involved, which explains the limited volume of money market activities, and this has meant the secondary market has been slow to develop,
(v) Issues of trust between commercial banks hampers the working of the inter-bank money market. The full development of this market might be long in coming.
This thesis attempts to begin dealing with some of these shortcomings by estimating a money demand function for Rwanda. To the best of our knowledge no such function has been published. If income forecasts are incorrect these should show up as odd elasticities in estimated functions. In addition, finding a stable money demand function without foreign or external effects may indicate the need to include these effects in future research. However, against this backdrop of the problems associated with monetary control in Rwanda, we feel that it is high time that an estimate of a base line money demand function be made. We do this in the next chapter and examine its features to ensure compatibility with current monetary policy and suggest possible amendments that can be made in any future research.
CHAPTER FOUR
DATA ANALYSIS, TESTING, EMPIRICAL RESULTS AND DISCUSSION