Monetary Policy Strategy of the National Bank of Georgia

1. Objective of the Strategy

The Monetary Policy Strategy(The "main directions of monetary and exchange rate policies") describes the main principles of the monetary policy in Georgia and the directions of its development. According to the Organic Law of Georgia on the National Bank of Georgia, the main objective of the National Bank of Georgia (NBG) is to ensure price stability in the country. Low and stable inflation is a necessary precondition for macroeconomic stability, which is crucial for achieving economic growth, low-interest rates and high employment. The more efficient monetary policy is the least costly to achive price stability. Correspondingly Central Banks always seek to increase the efficiency of monetary policy. Accomplishing the NBG’s Monetary Policy Strategy will improve the effectiveness of monetary policy in Georgia. 

2. Executive Summary

The monetary policy of the NBG relies on inflation targeting. The NBG sets its long-run inflation target at 3 percent. It should be noted that developing countries tend to have higher levels of inflation, which is mainly caused by rapid growth in productivity. However, at the recent stage of economic development in Georgia, the gradual reduction in inflation target was appropriate. Hence, from 2018, the inflation target of the National Bank of Georgia was reduced to its long-run level of 3%.

The inflation targeting regime requires a floating exchange rate given the free capital mobility (liberalized capital account). Under this regime the foreign exchange market is characterized by short-term fluctuations. These fluctuations tend to be even higher in small and open highly dollarized economies like Georgia, considering the modest foreign exchange market turnover and volatile capital flows. To smooth the excessive exchange rate volatility caused either by government or private sector operations, the NBG occasionally uses interventions on foreign exchange market by foreign exchange auctions. It is important to note that the NBG does not target any exchange rate level.

The efficiency of monetary policy has considerably improved after switching to inflation targeting. Since the activation of monetary policy instruments in April 2010, interest rate fluctuations have decreased on the market and GEL money markets have deepened. Money market development has enabled commercial banks to manage liquidity more efficiently and has made GEL resources more attractive for banks. Parrallel to the increase in trust of the refinancing rate, commercial banks have started to offer loans denominated in GEL with floating interest rate, which has significantly improved transmission of monetary policy. As a consequence, the liability larization of commercial banks has increased considerably. Exchange rate policy reform in 2009 is important to mention as well, which implies that foreign exchange interventions will be implemented only by means of foreign exchange auctions that are based on market principles. FX auctions have significantly reduced the need for NBG interventions in the foreign exchange market. The exchange rate became unpredictable in the short run that removed pressures of speculation.

These measures have significantly enhanced the transmission of monetary policy to the real economy and its importance in achieving macroeconomic stability. The NBG will continue working to strengthen the monetary policy transmission mechanism.

3. Inflation Targeting Regime 

The NBG switched to an inflation targeting regime in 2009. This regime implies the announcement of an inflation target in advance and management of policy instruments in a manner to achieve the target level in the medium term. Transparency and simplicity of communication represents one of the advantages of inflation targeting regime, because a predetermined single target enables NBG’s main goal to be defined precisely and allows the formation of accurate expectations about the direction of monetary policy. The inflation target is set annually for the following 3-year period by the NBG and is approved by the Parliament of Georgia. The main objective of the NBG – maintenance of price stability - is independent from other goals of the Government and this independence is ensured by the Constitution of Georgia and the Organic Law of Georgia on the National Bank of Georgia. 

Like all other major central banks, the NBG uses short-term interest rates as its operational tool. Changes in short-term rates are further transmitted to long-term interest rates and reflected in the economy. Monetary transmission mechanisms operates with a time lag, usually of around 4-6 quarters. Thus, changes in monetary policy instruments influence future inflation. This makes accurate forecasts of inflation especially important to echieve price stability.
The interest rate on refinancing loans represents the main instrument of the NBG to manage interest rates. The rate is determined by the Monetary Policy Committee and approved by the Governor. The refinancing (or monetary policy) interest rate is the minimum interest rate on one-week refinancing loans provided to commercial banks. In addition, the NBG uses other monetary policy instruments as well. 

To conduct an efficient monetary policy, the NBG relies on multilateral economic analysis and macroeconomic modeling. Macroeconomic models represent an effective tool for forecasting, taking into account the endogeneity of monetary policy. The models generate sound forecasts, but also provide clear instructions on how to set monetary policy instruments to return inflation to the target. 

4. Exchange Rate Regime  

Georgia operates a floating exchange rate regime. Georgia is a small open economy, integrated with the world economy and does not share optimal currency area with partner countries. As a result, fluctuations in the world economy influence the Georgian economy. For small open economies, the floating exchange rate can play a shock absorbing role. During external shocks, changes in the exchange rate can weaken the influence of these shocks on real economy, and protect economic growth and inflation. Thus, the floating exchange rate regime is the most optimal for Georgia. 

To support the FX market development, the NBG has implemented the exchange rate reform. The Tbilisi Interbank Foreign Exchange was replaced by foreign exchange auctions that currently represent the sole instrument for intervention on the FX market. After introduction of this new instrument, the need for the NBG interventions on the foreign exchange market and the NBG’s share in market turnover have both decreased considerably. This new policy has resulted in an increase in short-term exchange rate flexibility that is important feature of FX market. As a consequence, the exchange became less predictable in the short-run, eliminating incentives for destabilizing speculation, and so improving the stability of the GEL in the long run. Foreign exchange policy of the NBG implies minimum intervention in the foreign exchange market. The main goal of FX auctions is to smooth out excessive short-term volatility in the exchange rate due to temporary surges in inflows or outflows of foreign capital and to partially balance the private and government FX financing gap. In the long run, the NBG intends to further reduce foreign exchange interventions and eventually to eliminate them.

5. Monetary Policy Efficiency  

Switching to inflation targeting regime in 2009 was an important step toward improving monetary policy and enhancing its efficiency. Before inflation targeting, monetary policy was implemented under a monetary targeting regime which targeted a desired growth rate of the monetary base with the aim of controlling inflation. However, the previously stable relationship between what the NBG could control (monetary base) and the final objective (inflation) broke down over time. Therefore, monetary targeting became less efficient at fighting inflation and the need for a new regime evolved. 

The level of larization in the economy is an important feature for the efficiency of the monetary policy and its transmission to the real economy.To form a stable macroeconomic environment, the NBG constantly implements measures to encourage the use of the national currency. As a consequence, the larization level has increased and the efficiency of the monetary policy has improved.

Along with the introduction of the inflation targeting regime, monetary policy instruments (refinancing loans, standing facilities, reserve requirements) were activated in 2010 to strength monetary policy. Introduction of refinancing instrument enabled commercial banks to manage liquidity better. This enables commercial banks to reduce their operational cost considerably, which gives them the opportunity to offer loans in national currency at lower interest rates. Differentiation of minimum reserve requirements by currency has also encouraged the attraction of resourcesin national currency. Moreover, reserve requirements in national currency are to be met by an average stock on correspondent accounts during a two-week maintenance period. Such a framework of reservere quirements reduces the burden of required reserves for commercial banks and makes GEL resources more attractive.

Deepening of the money market in recent years has increased the efficiency of the monetary policy transmission mechanism. Longer maturities and increased volume of treasury securities in circulation have played an important role in the development of money market. The NBG also undertook measures to lower credit and operational risks. In particular, the NBG has organized the establishment of  trading platform in the Bloomberg system, where trading with securities and settlement is automated. Such a system reduces operational and transactional risks practically to zero. The development of  GEL money market, has increased monetary policy predictability, while the interest rate, liquidity and operational risks were reduced. As a consequence, the interest rate differential between  for the securities with different maturities has declined and interest rates became more tightly correlated. This resulted  in  better transmission of the monetary policy rate to long-term interest rates.

Supporting the loans denominated in GEL with floating interest rate is important for enhancement of monetary policy efficiency. Popularization of this type of loan has disbusred loans denominated in GEL, which caused a significant increase of loans larization. However, share of loans with variable interest rates is still very low in Georgia, while they are very popular in other developed and emerging economies. Such loans do not induce interest rate risks for commercial banks and allow them to reduce rates on these loans. These loans are also free from FX risks (like other GEL loans): this further decreases the debt service burden. 

Along with the deepening of the money market, introduction of new instruments on financial market is important for the enhancement of monetary policy efficiency. In line with the development of the market for government securities, the NBG will encourage the activation of private fixed income securities market. At the first stage, it is important to support the emission of GEL-denominated securities on the local market by international financial institutions. This type of instruments will be in great demand due to high confidence in the mentioned institutions. At the next stage of financial market development, the emission of corporate equity and debt securities can be encouraged.

6. Communication 

The communication of its main tasks, policy decisions and undertaken measures is one of the priorities for the NBG. By developing existing channels and introducing new means of communication, the NBG will be able to improve its credibility and to manage  inflation expectations.  For this purpose, the NBG has revised the structure of its publications, renewed the monetary policy section on its official website and developed new communication strategy. Besides, to ensure the transparency of the NBG and to keep the public informed, information regarding the NBG decisions, monetary operations or FX interventions is published in the form of press releases in a timely manner.  According to the new communication cycle, press conferences will be held quarterly after the monetary policy committee meetings, which are, followed by a meeting with analysts and the publication of the monetary policy report. 

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