Monetary Policy Framework
The Central Bank of Bahrain (CBB) is responsible for setting and implementing monetary policy in the Kingdom of Bahrain. Bahrain maintains a fixed exchange rate regime between the Bahraini dinar and the US dollar. The exchange rate peg provides an anchor for monetary policy,. Low inflation and a stable currency are important long-term features of the Bahraini economy which support a stable business environment and high levels of investment, both of domestic and foreign origin.
Bahrain has a free market economy, with no restrictions on capital movements, foreign exchange, foreign trade or foreign investment. The Kingdom has a leading position in the region as an open, free, transparent and welcoming environment for investors. The monetary policy framework is geared to support the general economic goals of the Kingdom.
Monetary policy instruments
The CBB uses three different types of instruments for the conduct of monetary policy:
•CBB offers a foreign exchange facility for buying and selling Bahraini dinars against US dollar at rates very close to the official exchange rate.
•CBB offers a set of deposit and lending standing facilities in Bahraini dinars to all retail banks. The interest rates on the standing facilities are the CBB policy interest rates. The CBB policy rates guide the short-term interest rates in the Bahraini money market, and ultimately influence the deposit and lending rates that the banks offer to customers.
•CBB requires retail banks to hold unremunerated reserves with the CBB. The reserve requirement system contributes to adjust the CBB's structural liquidity situation vis-à-vis the banking sector. The reserve requirement system is not intended to serve as an active monetary policy instrument for day-to-day liquidity management.
The CBB does not maintain any administrative controls over market interest rates. There are no interest rate caps or floors and the CBB does not seek to influence directly the cost of credit or the distribution of credit in the economy. The private sector is thus free to allocate credit as it sees fit.
The CBB monetary policy operations aim to ensure that the liquidity situation in the banking sector is appropriate. The Bahraini dinar liquidity of the commercial banks consists mainly of the current account balances they hold with the CBB. These balances, which can be traded between banks in the money market, fluctuate from day to day, mainly as a consequence of the Government's conversions of US dollar to finance its domestic expenditure, the commercial banks purchase of US dollars from the CBB, changes in the amount of currency in circulation and changes in the banks reserve balances with the CBB.
Why is monetary policy centred on the exchange rate?
Bahrain is a small open economy for which external trade, i.e. exports and imports, corresponds to more than 140% of GDP. It is therefore important to have a monetary arrangement which mirrors that of major trading partners. The Bahraini dinar is pegged to the US dollar. The peg has been effectively unchanged since 1980. The use of a large foreign currency as a nominal anchor for monetary policy is a frequent arrangement among small open economies and has proven to be successful if supported by appropriate fiscal and structural policies. The US dollar peg serves to enhance credibility and transparency of monetary policy to maintain financial stability.