Central Bank Autonomy: - why, what and how? Ahmed A.K.

N 1997
Why central bank should be autonomous?
The main purpose for which central bank autonomy is advocated is maintenance of price
stability. Price stability is sine qua non of any sustainable long term economic growth and
development. But price stability can not be maintained if central bank is not allowed to
vary the volume of money and is not enabled to refuse, when needed, to finance the
budget deficit of the overnment concerned. !onetary control and monetary instruments
to be used to maintain price stability should therefore be freely used by central bank
without feer and favor and without being constrained to serve any other purpose of
overnment however laudable and important that may be.
What central bank autonomy means"
# There are many attributes of central bank autonomy"
# Whether it can refuse credit to overnment
# Whether it can meet its e$penses without depending on overnment
# Whether its board of directors can function independently
# Whether overnor is independent in following monetary policy
# Whether the central bank is free to choose its monetary instruments
# Whether central bank is free to regulate banking system
%& 'entral bank in developing country has to be more than a mere bankers( bank. )t has
to be the voice of conscience to the overnment. . )t has to be a friend, philosopher and
guide to banks. )t has to attain commanding height, so that it can navigate through shoals
of political vicissitudes by means of its own compass * compass of high degree of
professionalism.+ * &.,.- &hmed.
.ow" /uropean central bank has the following broad features *
0. 'entral bank credit to overnment is entirely discretionary
1. 2nly indirect credit is permitted 3through acquisition of overnment securities by
central bank from a third party4.
5. )ndirect credit is unconstrained
6. -ational Parliament have no direct involvement in monetary polity
7. overnment deposits at the central bank are unconstrained
8. 'entral bank may act as overnment fiscal agent.
Md. Abdu !amad !arker "#ontroll$n% money u&&ly throu%h reer'e money $n
Ban%ladeh. 1997
'hanges in money supply have multidimensional effect on the macroeconomic variables
and therefore it needs to be prudently managed. )ndirect monetary management through
reserve money program ensures variation of money stock without distortion
With the initiation of P9:P, Bangladesh Bank has introduced this method of indirect
control and through auctioning of Bangladesh Bank bills and overnment treasury bills
and the ob;ectives of monetary policy are being tried to be achieved.
.owever due to e$istence of a number of bottlenecks such as underdeveloped money
market, narrow security base, absence of secondary market for the transaction of security,
prescription of :<9 for banks, the progress toward this direction is very little.
)f these obstacles can be removed and overnment deficit financing program can be
precisely determined, the %9eserve !oney Program+ might be very useful method of
controlled variation of money supply which will be largely helpful in ensuring
macroeconomic stability of the country.
9elationship between money supply and reserve money"
9! = ' > T > 9
' = 'urrency outside bank
T = Till money of ?eposit !oney Bank
9 = reserve of ?eposit !oney Banks with central bank
! = 30 > cu4$9!@3re > cu4
! = mm $ 9!
'u = currency deposit ratio
9e = reserve deposit ratio
! = money supply
!m = money multiplier.
)n Bangladesh the ob;ectives of monetary policy are tried to be achieved through
controlled variation of broad money and total domestic credit within the framework of
monetary program, where 9! is the operating target.
?emand for 9eserve !oney"
?emand for 9eserve !oney is estimated on the basis of targeted e$pansion of broad
money assuming a fairly stable money multiplier. This targeted demand for reserve
money is then compared with actual supply. This approach is e$plicitly related to the
analysis of Balance :heet of Bangladesh Bank. Arom the B@: of Bangladesh Bank the
supply source of reserve money can be presented in a form
9! = net credit to government > credit to public and private sector > credit to deposit
money banks > other assets 3net4 * Bangladesh Bank bills.
)n principle, although, Bangladesh Bank tries to equilibrate the supply of 9! with its
estimated demand through variation of -et ?omestic &sset and -et Aoreign &ssets, but
in practice, due to limitation to vary -A&, it tries to do so basically through the variation
of -?&. Bangladesh Bank can directly affect the supply of 9! through the supply of
credit to overnment Treasury Bills or Bonds or using the other instruments.
An analy$ o( monetary a%%re%ate $n Ban%ladeh " 1977 19)7* - +ab$bullah Bahar
The effectiveness of the central bank(s policy in controlling money supply depends on its
ability to determine the monetary base and the stability of the money multiplier.
Bangladesh bank could set reserve requirement. :ome element of money multiplier like
e$cess reserves and currency ratio depend on the behavior of the scheduled banks and in
the public which are not directly amenable control by the Bangladesh bank.
overnment policy in respect of fiscal deficit, has important effect on monetary base.
There should be proper and meaningful cooperation between the monetary and the fiscal
policy, if the general economic conditions in the country are not abnormal so that money
multiplier shows a fair degree of stability, then the Bangladesh bank will be able to
e$ercise sufficient measure of control on monetary policy.
Monetary &ol$#y: ,b-e#t$'e and #urrent &ra#t$#e $n Ban%ladeh .aru/udd$n Ahmed
" 1990*
!onetary policy is generally defined as the policy undertaken to control the supply of
money stock in an economy in order to attain certain predetermined ob;ectives.
&s money supply is a very important macroeconomic variable, the authorities e$pect it to
vary according to the greatest advantage of the society.
&lthough the economy of Bangladesh witnessed a relatively stable monetary
environment, reasonable growth of financial savings through the e$pansion of banking
network and increased flow of credit to the priority sector during the late 0BCDs and early
EDs, but the cost thereof has been rather high.
Weakness in institutional and management capabilities and interventions endangered the
soundness and effectiveness of the financial system very often.
'onsequently a national commission on !oney, Banking and 'redit was set up in 0BE6
to revive the entire gamut of the monetary and credit system and accommodate policies
for reform. The commission suggested that administered interest rates, credit ceilings and
directed credit program combined with refinance facility limited to the scope of the sound
monetary management by 'entral Bank and inhibited resource allocation among various
sectors of economy and thereby distorted the entire financial sector.
A:9P initiated in 0BBD was primarily to enable the banking sector to play a more
effective role in country(s development program as also to enable it to make allFout
efforts in mobiliGing and allocating required resources to various sectors of the economy.
The main ob;ectives of A:9P were as follows"
0. radual removal of distortions in the interest rate structure
1. Providing increased incentives for priority sector lending and making subsidies in
these sectors e$plicit and transparent.
5. Promoting better monetary management by moving towards fle$ible and indirect
instruments of monetary control.
6. /stablishing appropriate and uniform accounting policies including classification
of loan portfolio, provisioning against loan losses and recapitaliGation.
7. :trengthening the legal framework for debt recovery and revision of regulation
affecting the banks
8. )mproving the capital market of the country.
)nterest rate liberaliGation"
Banks were initially allowed to fi$ their own rates within prescribed bands. :ubsequently
interest rates bands e$cept 5 priority sectors agriculture, e$port, small and cottage
industries were abolished from 0
st
&pril 0BB1. )nterest rate band on deposit abolished
from the same date.
/$change 9ate Policies"
1he Monetary 1heory o( B,2: !u-$t Kant$ 3a "4555*
The two ma;or heads of accounts of the B2P are 3a4 current account 3b4 capital and
financial account. The monetary survey structure of a country for any particular period of
time can be e$pressed by the following identity"
-A& > -?& = Broad !oney3&4
-A& = Aoreign &ssets * Aoreign liabilities 3B4
-?& = ?omestic credit * domestic liabilities net 3'4
/quation B includes 3i4 international reserves, 3ii4 e$port and import and 3iii4 net capital
inflow and outflow etc.
2ne importance of monetary policy is to restore equilibrium in money market. :ome of
the macroFvariables such as nominal interest rate, ?P and inflation rate are affected by
contractionary@e$pansionary monetary policy and thus it has a significant effect on
domestic credit as well as balance of payment.
This paper e$amined annual data of Bangladesh both narrow and broad money supply.
The result suggest that reserve flow e$perience of Bangladesh over period from 0BC7 *
B7 has been broadly in conformity with the monetary approach of B2P.
)ncreases in output and the price level are associated with increase in reservesH result in
reserve inflow, whereas increases in domestic credit and money multiplier resulting in
reserve outflow.
The findings suggest that the monetary authority in Bangladesh can attain their desired
stock on international reserves for any given demand for money through their control of
domestic credit.
.$nan#$al 6e(orm and tab$l$ty o( the money demand (un#t$on 7at$(, 4555
The financial sector measures that were taken in Bangladesh during 0BEDs and 0BBDs
have implications for the stability of the money demand function and hence the conduct
of monetary policy. With the rela$ation of direct control over the interest rates the interest
rates have began to play a greater role in transmitting monetary effect to the real sector of
the economy.
)nstability in money demand function has implications for the relationship among money,
income, interest rate and prices and hence conduct of monetary policy. When money
demand function is unstable, then velocity becomes unpredictable as relationship
between inflation and money supply growth rate becomes imprecise.
)mpact of financial reform on money demand function"
0. Promote financial market development, results in availability of financial
instruments with attractive yields, which may lead to gradual portfolio shifts from
away from monetary assets.
1. Promotion of competition among financial institutions lower transaction costs,
cause money demand function to respond more rapidly to interest rate changes
5. The development of rural banking system may shift fund from informal sector to
banking sector and this may affect the holding of monetary aggregates.
9egression result shows that real income and interest rate are the ma;or determinants of
money demand in Bangladesh. !erely demand function become unstable during mid
0BE6 and during 0BBDs.
+ab$b, !.M. Ahan, 8 Can Ban%ladeh9 :;ternal ($nan#$al o&enne be l$nked to the
#ountry9 e#onom$# %rowth?<4554
The empirical analysis revealed that openness has a beneficial impact through its positive
influence on financial deepening and domestic long term investment. .owever there is no
indication that financial openness has been contributing in improving the productivity of
domestic capital of Bangladesh.
Ahmed, A.K.N, 8Ma#ro mana%ement o( the e#onomy and monetary &ol$#y.<4554
!onetary policy has an important role to play in macro management of the economy, but
in order to be effective, it has to be part of economic policy of the country. This is more
true in case of economies which have embarked on economic growth.
!onetary policy should not throttle economic growth and economic growth should not
threaten monetary stability.
!uch of the economics is an attempt to analyGe how a society of privately owned labor
and capital will in fact be combined into production.
There cannot be absolute autonomy for the central bank and central bank governors have
to learn to live with politicians in order to be effective. This is why central banking is
called more and art than science.
&n important component of sound fiscal policy is the shift of government borrowings to
market rate of interest. &nother component is to curb government access to central bank
to finance its deficits in order to e$pand the scope of discretionary monetary policy.
& sound macro economic management entails"
0. /limination of revenue deficit, a manageable fiscal deficit, elimination of wasteful
subsidies not targeted to the poor.
1. <ow and manageable current account deficit.
5. <ow interest rate, low e$ternal debt, low short term debt in overall e$ternal
balance
6. Profit generation by public sector enterprise
7. :elf financing public utilities like gas, power, irrigation, water, and public
transport
8. &n increase in ta$F?P ratio reached by rapidly industrialiGing counties of
around 07I of ?P.
This can be done by taking following measures"
0. 9eduction of government revenue deficit in a phased way towards nil figure.
1. 9eduction of government fiscal deficit to the lowest level within shortest possible
time
5. 9eduction of the government liabilities to ?P at least 7DI by 0D years
6. Juarterly review of fiscal trends in relation to budget
7. Prompt proportionate cuts in e$penditure when there is shortfall in revenue or
e$cess of e$penditure over budgetary provision.
8. 9aising of funds by overnment from the market by paying market rates of
interest through central bank auction and resist temptation of raising funds
through various savings schemes by offering higher than market rate of interest.
C. <ike K,, preparation and publication by the government at the end of fiscal year,
a report detailing the new assets that have been created by using the amounts
provided for in capital budget.
!onetary field"
0. & central bank should stop lending to government through adhoc treasury bills
1. 'entral bank should sanctions to government a limit of ways and means advance
to ride over temporary gap between receipts and payments.
5. 'entral bank should not vary the level of reserve requirement only to enable
government to raise money through floatation of treasury bills at lower rate of
interest from captive market.
6. 'entral bank should resort and more to open market operations.
7. Bank rate should be used more as a signaling rate with several key rates like
refinance rate to influence the lending rate of the banks.
8. 'entral bank should finance at refinance rate against collateraliGed securities, and
that too, up to a specified amount based up on the volume of loans and loanF
deposit ratio of the particular bank.
C. 'entral bank should dry to establish an informal corridor for short term rates with
fi$ed repo rates providing the floor and bank rate the ceiling.
E. 'entral bank should make conscious effort to maintain orderly conditions in the
foreign e$change market, monitor the linkage of foreign e$change market with
domestic money market and intervene if necessary.
B. 'entral bank has to take steps to remove thinness of domestic and foreign
e$change market.
0D.'entral bank should have well defined policy for an e$it door for liquidating
unsound banks promptly, before they poison the banking system and add to the
no. of sick and ailing banks.
The basic thrust of fiscal and monetary policies should not be set containing the fiscal
deficit, but to alter the composition of fiscal deficit to ensure the macroeconomic
stabilities. To ensure more equitable distribution of resources. )t has been found that there
is no trade off between distribution and efficiency.
).. Patel, an eminent )ndian economist and former governor of 9eserve Bank of )ndia
has stated, %<asting economic health requires good sustenance 3education, training and
healthy environment4 an action life 3hard work, competition, enterprise, innovation and
even animal spirit4, a disciplined and moderate temperament 3good government, rule of
law, respect for law, willing to cooperate and perform civic duties and restraining from
destructive agitation4 and a proper balance between today and tomorrow 3savings, sound
fiscal and monetary policies and care of natural resources and environment4+ .
%)n the ultimate analysis, no management by economic instruments alone can deliver us
from basic or fundamental infirmities, such as low rates of savings, or an inefficient use
of the savings and generally low productivity all around. These have to be dealt with on
their own terms by a combination of economic, social and political steps which take time
to gain hold in order to yield results. There are no antibiotics available for economic
health.+
/conomic cycles, economic downturns and upturns call for different sets of appropriate
fiscal and monetary measures to pull and push the economy without drifting from, or
being inconsistent with long term ob;ectives of growth and development. :ince central
bankers are powered to contain aggregate demand through restrictive monetary policy,
but not in reversing it, it can only pull and not push the economy. Therefore in downturn
the onus squarely falls on the fiscal policy as a counterFcyclical tool in pushing the
economy to a higher level of equilibrium and growth. What necessary in such situation
are liberal policy measures that would force the economy from the shoals of rigidities,
institutional or structural which would facilitate both utiliGation of the e$isting capacity
and enhancement of productivities through efficiency gains.
)n the 5D years of life of Bangladesh bank one governor was removed overnight and
posted as !? of a commercial bank, a position he refused and quit. &nother governor
resigned on his own because he did not want to serve as coattail of ministry of finance.
&nd yet another governor has fired illegally two weeks before the end of his tenure
without assigning any reason in blatant disregard of the provisions of Bangladesh Bank
2rder.
Noman, A.N.K, 8 :;ternal ho#k to a l$beral$=ed e#onomy: $mulat$on w$th a C>:
model<- 4551
This study e$amines the impact of international market price shocks on the economy of
Bangladesh. )n this '/ model the impact on the domestic economy is basically
measured in terms of domestic output, value added, employment, e$ports, imports and
households consumptions. )mpact are also measured in terms of agriculture in order to
separate the impacts on agriculture in comparison to nonFagricultural sectors. 9esult
shows that the increase in petroleum and chemical product 3fertiliGer, insecticides etc.4
prices in international market may affect economy severely and could reduce households
welfare by reducing their level of consumption. )t also reduces government revenue and
worsen budget deficits through contracting the economy.
The real e$change rate depreciates and government revenue and savings fall, changes are
much bigger with full liberaliGation to without liberaliGation.
The demand for imported input falls, production decreases as most of the inputs do not
have substitutes in local market. &s production shrinks, demand for labor falls, private
consumption decreases. /$port will also fall.
Khan, !yed Ahmed, 8 An o'er'$ew o( e;ternal e#tor o( Ban%ladeh: 4551
Bangladesh like many developing countries pursued import substitution strategy in her
trade policy during the post liberation period to protect domestic industry and to develop
domestic industrial base and save foreign e$change needed for import.
?uring the decade of EDs and beginning of BDs there has been a marked departure in the
official policy.
&fter 0BBD Bangladesh embarked on a freely liberaliGed trade regime with few items of
negative list of imports, removal of quantitative restrictions, phased reduction in tariff
rates, ad;ustment in e$change rates and devaluation of taka
Larious e$port promotion measures were undertaken in Bangladesh since 0BEDs to
augment e$port. The e$port sector in Bangladesh depicted a relatively slow growth
during the post liberation period and a faster rise during 0BE6FE7 to 0BB6FB7. There was
also a significant shift in the structure of e$port sector from primary to manufactured
goods and from traditional to nonFtraditional goods.
Bangladesh has been undertaken trade liberaliGation measures gradually since 0BEDs. The
average nominal tariff rates of Bangladesh fall dramatically from B6 in 0BE6 to 16.8 in
0BB7FB8. Juantitative restriction fell from 6D in 0BEB to 0D in 0BB1.
Mear Tariff 3 wt. avg4 Tariff 3unweighted4
0BB1FB5 15.8 6C.6
0BB5FB6 16.0 58.D
0BB6FB7 1D.E 17.B
0BB7FB8 0C.D 11.5
0BB8FBC 0E.D 10.7
0BBCFBE 08.D 1D.C
0BBEFBB 06.0 1D.5
0BBBF1DDD 05.B 08.C
1DDDF1DD0 01.1 0C.0
Withdrawal of licensing requirements, reducing formalities of <@'
?uring 0BBDFB0 to 0BB6FB7 the to tariff rate was bought down from 57D I to only 8DI,
with rates falling into only five tariff slabs in place of twelve.
)n 0BBCFBE tariff again reduced to 61.7I and 5C.7I in 0BBBF1DDD.
/$port incentives can be in three forms 04 fiscal incentives, 14 financial incentives and 54
institutional incentives.
Aiscal incentives" duty drawback facility, ta$ holiday, bonded warehouse facility, income
ta$ rebate, waiving of import license fees, concessional rates for capital machinery
import, rebates on freight charges, rebates on service charges etc.
Ainancial incentives" 'ash assistance to promote backward linkage industries, availability
of credit at concessional interest rates, provision of import under back to back <@',
retention of foreign e$change earnings by e$porters.
)nstitutional incentives" setting up of /PB, e$port credit monitoring cell at BB, /$port
credit guarantee facilities etc.
?egree of 2penness of economy"
0BC6FC7 0BE6FE7 0BB6FB7 1DDDFD0
/$p@?P 6 I 8.BI 05.5I 0C.EEI
)mp@?P EI 0B.CI 11.8I 17.CI
With the steep rise in the import payments, if the comparing rise in e$port receipts did not
take place, trade deficit would have been much wider in Bangladesh. &t the same time
e$porters access to imported inputs has been more important for e$port growth then the
internal e$port subsidies.
The behavior of B2P
The behavior of B2P indicates the overall performance and strength of the e$ternal sector
of a economy. The B2P in Bangladesh came under severe pressure immediately after
liberation mainly from 3i4 rising demand for food import 3ii4 share rise in all price,
3iii4)nstability in e$port earnings. ?emand for e$penditure for rehabilitation and
reconstruction of warFtom economy. The deficit of 'urrent account B2P stood at N 0DD5
m in 0BC6FC7 3 C.DEI of ?P4, which declined to 65Bm 3 8.61I of ?P4, in 0BC8FCC
which declined to O65Bm 38.1I of ?P4 in 0BC8FCC.
Bangladesh entered into standby arrangement with )!A in 0BC6 and Taka was devalued
by 5CI against K:? in !ay 0BC7. )nternal corrective measures have been taken such as
3i4 increase of price of public utilities 3ii4 reduction of subsidy 3iii4 raising of bank rate.
The current account deficit rose to O 0658 m 300.15I of ?P4 in 0BCBFED. )n 0BE7FE8
this deficit reduced to O 0D77 m 38.E7I of ?P4. This deficit is further improved in
0BBDFB0 to O BE0 m 36.0BI of ?P4
?rawing of Bangladesh in the period 0BC8FE1 from )!A stands at :?9 8EB.5B m under
various facilities. The ad;ustment policies of Bangladesh pursued under )!A facility
bought significant impact on economy. 3&hmed, 1DD04
Bangladesh faced highest B2P deficit 300.15I of ?P4 in the fiscal year 0BCBFED
because of large shortfall in domestic food production and rise in prices of petroleum, oil
and lubricant items.
Policies for e$port promotion and import substitution was successful 3&hmed, 1DD04. &s
a result deficit in the current account balance declined from O BE0 m in 0BBDFB0 to O 886
m or 31.1EI of ?P4 till 0BB6FB7. Thereafter current account deficit continued to decline
till 0BBBF1DDD.
Bangladesh Taka was declared convertible for current account transaction on !arch 16,
0BB6 and Bangladesh got &rticle L))) status of )!A.
The world bank study 30BEC4 classified Bangladesh as strongly inwardForiented country
prior to 0BE8 out of 60 developing countries. This study based on the following indices
3i4 effective rate of protection 3ii4 use of direct control like quota and import licensing
scheme 3iii4 use of e$port subsidies 3iv4 degree of e$change rate overvaluation. :ince
0BB1 elaborate policy measures were undertaken to liberaliGe the trade regime of
Bangladesh.
&ll macroeconomic indices of Bangladesh depicted notable improvement during 0BB1FB8
period compared to 0BE8FBD period. This success mainly due to good harvests in
consecutive years after 0BBD, moderate inflation, declining trend of B2P deficit,
increased e$port earning, larger workers, a fairly fle$ible e$change rate etc. But the
domestic savings rate remains very low in Bangladesh and the country had resource gap.
?isbursement of foreign aid against commitment continued to decline 3&hmed, 1DD04.
)nflow of A?) in Bangladesh remained insignificant. )n recent times gases, and power
sector, telecommunication are dominated the inflow of A?).