EB-609(Central Banking: Regulation and Supervision)

23
rd
Batch, MBA (Evening) Program
Page 1

Central Banking: Recent Trends and Debates


Central Bank Independence
The term autonomy, or independence, in context of Central Banks, refers to how freely the
monetary policy makers can conduct policies with little or no interference from the
government. Also referred to as the autonomy of Central Banks, the definition of
independence considers two important aspects. They are political independence and
economic independence, However, nowadays these aspects have more popular names: Goal
independence, Target independence and Instrumental in dependence.

1) Goal Independence: Allows the Central Bank to decide its own monetary goal and/or exchange
rate system, exclusive to the direct influence of the politicians. In the case of a floating
exchange rate system, the central bank solely concentrates on the monetary policy. Some
common monetary goals are maintaining price stability, controlling money supply or increasing
real growth in the economy
2) Target Independence: When the central bank is goal dependent, i.e. the state decides the
macroeconomic objectives, it lets the central bank set the target value to the goal and to come
up with the policy instruments with which it will achieve the target. For instance, if the state
wants to keep the inflation rate at a low level of 2 percent, it will probably adopt a contractual
monetary policy where the interest rate is set at a very high level.
3) Instrumental Independence: This is probably the least independent dimension among
the three that we have been discussing. The government consults the central bank and
sets the monetary target. The Central Bank is said to be instrumentally independent as it is
free to choose the policy tools to attain a macroeconomic goal. Besides that, it is both goal
dependent and target dependent on the government. The instruments applied by the bank are:
Open-market operations, discount lending and reserve require.

The Legal Measure: According to Cukierman, Webb, and Neyapti (1991), the legal measure of
independence of a central bank is based on four criteria.
I. Appointment of chief executive: A bank is viewed to be more independent if the chief
executive is appointed by the central bank and not the prime minister or the
finance minister, and has a long term of office.
II. Government involvement in policy decisions: the independence is greater as the policy
decisions are made with less and less participation of the government.
III. Goal of monetary policy: When price stability is given the maximum priority, a bank is said
to have a high level of independence.
IV. Government borrowing from central bank: Finally, the level of independence is greater if
more restrictions are placed on the ability of the government to borrow from the central
bank.

Developed Country vs. Developing Country
A developing country normally has comparatively low level of affluence and
more unemployment rate. In developing countries, there is low per capita income, poverty, less
education level and low capital formation. Such countries are fighting to get these things, but
might not have reached them. These countries are usually suffered from war, disease, poverty,
natural disasters, etc.

The developed/advanced countries have developed economies. They have technological
improvements, excellent roads, a steady government etc. This level of economic development
usually translates into a High GDP per capita (average income), Good education, Good health-care,
and Death &birth rate are almost the same.
EB-609(Central Banking: Regulation and Supervision)
23
rd
Batch, MBA (Evening) Program
Page 2



Developed Country vs. Developing Country

Roles played by Central Bank in developing countries
In the developing countries, the central bank has to play a much wider role. Besides performing
the traditional functions, the central bank has to undertake responsibility of economic growth with
stability in these economies. Moreover, since the developing countries do not have well- organised
money and capital markets, the central bank has a crucial function to develop the banking and
financial system of the country. The central bank performs the following developmental and
promotional functions in the developing countries.

1. Traditional Functions: The central banks in the developing countries perform both traditional
and non-traditional functions. The traditional functions of the central bank are: having the
monopoly of note-issue; acting as banker to the government; serving as bankers' bank;
functioning as the lender of the last resort; controlling and regulating the credit; and
maintaining the external stability.
2. Economic Growth: The central banks in the developing countries should aim at promoting the
process of economic growth. Economic growth requires sufficient financial resources. The
central bank can ensure adequate monetary expansion in the country. Moreover, as a banker
to the government, the central bank can provide funds for initiating investment in the public
sector.
3. Internal Stability: Along with the objective of economic growth, the central bank should also
attempt to maintain internal price stability. The developing countries are susceptible to
inflationary pressures mainly due to supply -in elasticities in the short period. The central bank
should adopt such a monetary policy that can control inflationary tendencies and ensure price
stability.
4. Development of Banking System: The developing and underdeveloped countries do not have
well-developed banking system. In such an economy, the central bank should not only take
measures to develop an integrated commercial banking system, but also should not hesitate
undertaking directly the commercial banking functions.
Developed Country Developing Country
Also called industrialized countries & more
economically developed
Form of government(Democracy)
Free market economy
Lack of corruption
More dependent on manufacturing than
agriculture
Prevalent technology
Country with low standard of living
Also called third world countries
Undeveloped industry
Lack modern technology
Low level
o Education
o Healthcare
o Life expectancy
Good educational system; school
required
Schooling not available to all citizens of country
Widely available health care. Poor health care; not enough doctors.
Many manufacturing and service industries.
Farmers use technology.
Live by subsistence farming in rural areas. Few
businesses.
Participate in international trade Few items to trade
People mostly live in cities. People live mostly in rural areas.
United States, Japan, Germany, France Mexico, Brazil, South Africa, Thailand
EB-609(Central Banking: Regulation and Supervision)
23
rd
Batch, MBA (Evening) Program
Page 3

5. Branch Expansion: In developing countries, the commercial banks generally concentrate their
branches in the urban areas. In order to extend credit facilities to the agricultural sector, the
central bank should prepare programme for branch expansion in the rural areas.
6. Development of Financial Institutions: Development of the leading sectors of the economy
such as agriculture, industry, foreign trade, etc. requires long-term finances. For this, the
specialised financial institutions should be established which provide term-loans to these
sectors.
7. Development of Banking Habits: Through its various credit control instruments (i.e., bank
rate, variable cash-reserve ratio, etc.) and by providing discounting facilities to the commercial
banks, the central bank exercises full control over the activities of commercial banks. This
creates public confidence in the banking system and helps in the development of banking
habits of the people.
8. Training Facilities: A major difficulty in developing the banking system in developing
countries is the lack of trained staff. The central bank can provide training facilities to meet the
personnel requirements of the banks.
9. Proper Interest Rate Structure: The central bank can help in establishing a suitable interest
rate structure to influence the direction of investment in the country. In underdeveloped
countries, a policy of low interest rate is necessary for encouraging investment and promoting
development activities. Again, by adopting different interest rates, the central bank can
increase productive investment and discourage unproductive investment.
10. Other Promotional Roles: The central bank can provide a number of other promotional
facilities. For example, (a) it can adopt policies to provide help to the various priority sectors,
such as agriculture;, cooperative sector, small scale sector, export sector, etc. (b) it can provide
guidelines to be followed by the planners about some definite patterns of economic and
investment policies; (c) it can publish information regarding the state of the economy and
promote research in money and banking.

In short, the central bank has to play not only regulatory, but also developmental role in the
developing countries. In the words of Planning Commission, the central bank has to take "a direct
and active role (a) in creating or helping to create the machinery needed for financing development
activities all over the country, and (b) in ensuring that the finance available flows in the directions
intended."

EB-609(Central Banking: Regulation and Supervision)
23
rd
Batch, MBA (Evening) Program
Page 4

Information Sharing and Cooperation Between The Central Bank and The Government
In many countries the world over, the central bank has been given the mandate to preserve price
stability as its single or primary objective, and been granted autonomy from government to make
sure that short term political considerations do not interfere with achieving this objective. In
principle, there is a clear division of responsibilities and accountabilities between the central bank
on the one hand, and the government and the Minister of Finance on the other hand. Even so,
information sharing, cooperation and coordination between the central bank and the government
are important in a number of respects.

Clarity of framework and objectives: In general, a strong appreciation of the different objectives
and operating frameworks of the central bank, the fiscal authorities and development institutions
(where applicable) will be conducive to a fruitful dialogue among them, because information and
views are shared more easily when all parties understand and respect the others rights and
responsibilities.

Coordination of monetary and fiscal policy: If the fiscal authorities know the central banks
policy reaction function and its formal or informal analytical model, they can anticipate the
monetary policy response to a given fiscal action and adjust the action accordingly. In principle,
coordination between monetary and fiscal policy can thus be achieved without negotiations
between the monetary and the fiscal authorities, and the central bank can take advantage of being
the first mover (by establishing a credible reaction function), which is important to avoid
undermining its price stability objective.

Coordination in other areas: In some areas other than monetary policy, coordination between the
central bank and the government may need to be quite close. For example, this is the case for fiscal
agent functions of the central bank. In addition, the central banks financial sector regulatory
functions or advisory responsibilities (as well as its own participation in the financial system) allow
it to foster the development of the sector, which will require close coordination with the
government, for instance on legal reform.

Development role of the central bank. The single most important contribution central banks can
make in industrialized and developing economies alike is to provide an environment of
monetary stability, which in turn is conducive to economic growth and development. At the
margins of this principle, central banks in some industrialized countries are making an effort to
focus their activities ever more on this core responsibility. Central banks have played an important
role in developing the financial sectors capability central banks in developing countries often
prefer to limit their development functions to the financial sector, where they are best placed to
contribute to infrastructure building and human capital formation.

Macroeconomic management challenges: In low-income countries the dependence on selected
commodity exports can make them highly susceptible to terms-of-trade shocks, the predominant
role of the primary sector can lead to large fluctuations in output, demand and government
revenues (in part simply as a result of fluctuations in the weather), and the volatility of aid flows
can be a further huge challenge in trying to stabilize output (Bevan 2005). In addition, if market
imperfections are such that monetary policy can have permanent effects on real variables, the
central bank may be subject to yet more political pressures than in more advanced emerging
market economies or industrialized countries.

Oil and other resource revenues: An important aspect of policy coordination in a number of
developing countries concerns the management of oil and other resource revenues. For oil-
exporting countries, two approaches may be used. One is to budget at a conservative, normal oil
price. This reduces the danger of large budget deficits if prices decline suddenly. Proper governance
arrangements for such resource funds are essential but can be difficult to devise and implement.
EB-609(Central Banking: Regulation and Supervision)
23
rd
Batch, MBA (Evening) Program
Page 5


Importance of Central Bank Autonomy
Both price and financial sector stability are important for achieving sustainable real economic
growth. Inflationparticularly variable inflationover a certain threshold impedes sustainable
economic growth. The effectiveness of the price mechanism to allocate scarce resources is impinged
by the noise created by inflation. Investment and savings decisions are distorted, as people are
trying to protect themselves against inflation. Moreover, inflation redistributes wealthmainly from
the poor to the wealthy owning land, real estate, or stocks.

Furthermore, although governments may be tempted to use the inflation tax, high inflation also
affects the budget negatively due to higher interest rates and lags in tax collection. Although it is
tempting to use inflationwhich now is generally accepted to be primarily a monetary
phenomenonto solve short-term problems, it will hamper sustainable real economic growth by
postponing addressing the underlying structural challenges.

It is the prerogative of the state to conduct monetary policy, but it may not be credible if done by
the government. In the short run, the government has many competing objectives, including being
reelected. Even if the government states that it will pursue price stability, the general public knows
that it has incentives to compromisethe so-called time-inconsistency problem (Kydland and
Prescott, 1977). The public will accordingly require a risk-premium in the form of higher interest
rates, which impede sustainable economic growth. The delegation of authority to conduct monetary
policy to an autonomous and accountable central bank with clearly defined objectives can enhance
both credibility and flexibility. In addition to price stability, financial sector stabilitythat is a
sound and stable financial system including an efficient payment systemis also important for a
market economy to realize its full potential. An autonomous and accountable central bank may
help prevent that undue influence adversely affects the financial sector.

EB-609(Central Banking: Regulation and Supervision)
23
rd
Batch, MBA (Evening) Program
Page 6

Aspects of The Financial Autonomy of Central Banks
This note began with the modern triangle of central banking (an autonomous central bank
pursuing price stability in a transparent manner and being held to account for its performance)
and then discussed practical aspects of the interaction between the central bank and government
in this type of arrangement. The remainder of the note summarizes aspects of the financial
relationship between the central bank and government that have a bearing on the policy autonomy
of the central bank.

Three aspects of the financial autonomy of central banks may be distinguished: (
1) the ability to set the terms and conditions on the items in the central banks balance sheet
this is essential for the conduct of monetary policy;
2) having the means to bear any losses that arise from central bank operations and having
appropriate rules to allocate profits (including rules that govern the accumulation of capital
and reserves); and
3) the ability to cover operating expenses, and in particular to set salaries (typically the single
largest component of operating costs) in a manner that allows the central bank to attract and
retain the professional talent it requires.

Concerning the first aspect, monetary policy autonomy may be at risk if the central bank can be
obliged to lend to the government or provide it with implicit or explicit subsidies in other ways, for
example by supporting the price of government debt. Where financial markets are well developed,
this risk is the principal reason why lending to government is typically prohibited when the central
bank law is modernized.

At the same time, practical experience shows that it can be very difficult to convince governments,
particularly in low-income countries, to agree to a reform of the central bank law that includes the
wholesale prohibition of lending to government. To address this problem, great efforts have been
made to draft central bank laws that limit government access to or facilitate a gradual weaning of
the government off central bank credit, but not much is known about how effective such provisions
are in practice.

The second aspect of financial autonomy concerns an adequate level of central bank capital in
relation to the risks the central bank is expected to absorb, as well as clear and consistent
provisions on accounting for valuation changes, on the creation of reserves, and on the transfer of
a central bank surplus (or loss) to the government.

In many cases, the costs of providing services to government can be covered by pricing them,
which also addresses the problem of implicit subsidies and competitive distortions. However, in
practice it may be hard to agree on terms with the government, or the central bank law may
restrict the pricing of some or all services to government. To illustrate, in a 2004 survey, half of the
emerging market economies and a third of the industrialized economy central banks did not price
services to the national government at all.