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Alternatives to central banks in small developing economies: Do all countries need full-fledged central banks?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1982
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Charles Collyns

In the developed world, the central bank is entrusted with a variety of public responsibilities and is endowed with a corresponding range of executive powers. It provides the national currency, determines its rates of exchange with other currencies, and manages the reserves of foreign assets. The central bank also acts as banker to the government and the executor of monetary policy—both of which contribute to macro-economic management. In addition, it serves as banker to commercial banks and regulator of domestic financial institutions, seeking to preserve the stability of the financial system. In carrying out all these tasks, the central bank is usually given considerable executive independence from government, on the principle that financial policy—like the administration of justice—must be able to resist undue political pressures.

Central banks in developed countries typically operate in a highly complex economy and as part of a sophisticated financial system. The situation in a small developing country may be very different. The economy is often dominated by a limited range of exports and faced with terms of trade beyond domestic influence. The financial system may be rudimentary, based on foreign-owned commercial banks that finance commerce and export industries, an informal credit network that serves much of the rural economy, and an existing monetary authority that is little more than a currency board. The population is usually short of manpower trained in the technicalities of finance. In these circumstances, many of the traditional central banking functions are either impracticable or less pressing, while altogether different tasks may assume greater relevance. For these reasons, many developing countries have not established full-fledged central banks, but instead have created institutions more suited to national needs, capabilities, and aspirations.

A different role

In a small developing economy, the scope for monetary policy is very different from that in a complex developed country. Domestic output is determined more by supply conditions and the country’s terms of trade than by levels of domestic demand. An expansion in domestic credit aimed at bolstering domestic spending will rapidly be dissipated in a payments deficit and/or in inflation; any impact on output will be limited and temporary. Considering also the considerable uncertainties and response lags involved, countercyclical fine-tuning would be particularly difficult to apply successfully.

But monetary policy can make a major contribution in these countries by establishing a monetary environment conducive to long-run growth. A country following an export-oriented development strategy ideally requires a stable exchange rate, currency convertibility, and relatively unrestricted capital flows. Domestic inflation will need to be close to world levels to maintain competitiveness, and the current account deficit will have to be at a level sustainable by foreign capital inflows. These objectives require close coordination between growth of income and expenditure and hence between the long-run rates of expansion of domestic credit and demand for monetary assets.

In a developing country, the authorities are also concerned to mobilize sufficient domestic savings to finance the development plan, and to channel savings toward investment priorities. The extent to which monetary policy will be able to influence domestic interest rates and credit conditions is limited, however, by the access residents have to international capital markets and the strength of their preferences for domestic as opposed to foreign assets. Monetary policy must be passive if foreign assets are both easily accessible and readily acceptable. To increase monetary independence, many countries impose controls on capital flows abroad that at least raise the costs of obtaining foreign deposits even ii they do not block all flows. In any case, domestic wealth holders will have a certain preference for local deposits that are more liquid, and hence more convenient, than foreign ones. The authorities will then have some flexibility to set interest rates apart from world levels.

Another constraint on monetary policy in the small developing economy is the rudimentary character of the banking system and financial markets. In consequence, the policy instruments typically used in developed countries to influence monetary conditions are often unsuitable. Markets for government securities and short-term commercial assets are frequently limited; hence, policy intervention in these markets could well lead to destabilizing fluctuations in interest rates and prices. Further, the system’s response to variations in the central bank discount rate may be weak or even absent. Monetary policy in developing countries generally uses more direct approaches—such as direct regulation of commercial banks’ deposit and lending rates, variation of prudential reserve ratios, and control over the volume of credit available to banks and government.

The monetary authorities in small developing countries can also play an important part in promoting indigenous financial institutions. As long as the financial system is dominated by foreign subsidiaries that have access to their parents’ reputation, technical expertise, and capital, close banking supervision or provision of lender-of-last-resort facilities may not be a pressing priority. But the monetary authority’s regulation and support are essential if local enterprises are to compete successfully and gain the confidence of the deposit-holding public. Indeed the monetary authority may need to be entrepreneurial in setting up or funding new institutions—such as specialized banks, deposit insurance schemes, or unit trusts—which if not immediately profitable are nonetheless important components of a developing financial infrastructure.

Social and political factors influence the practice of central banking in small developing countries. A shortage of indigenous personnel who are both willing and capable may limit central banking activities, particularly those functions requiring an intensive application of technical expertise—such as banking supervision and economic research. An equally important and more controversial issue is that of independence from government. The conventional wisdom is that a central bank should have a say in policy decisions but not the decisive vote: a less orthodox view is that monetary authorities must be fully independent to seek monetary stability irrespective of politicians’ macroeconomic objectives. It can be argued that the case for independence is particularly strong in the Third World. Governments in these countries have often succumbed to the temptation to use rapid monetary expansion for deficit finance, effectively applying an inflation tax as domestic prices rise. An independent monetary authority could deny the government the use of this retrogressive tax instrument and force it to make more fundamental reforms of the tax structure. How such independence may be guaranteed in a closely knit and possibly unstable society is another matter.

Central banking in industrial countries has evolved slowly. By contrast, newly independent developing countries have usually been quick to replace the inherited colonial institution—usually a currency board with powers to substitute local for foreign money but not to create money by fiduciary issue. Rather than simply adopting the traditional formulae of central banking legislation and organization, considerable attention has been paid to modifying these formulae to match the new institutions to their national context. The outcome is a great variety of institutions but nevertheless a variety from which some common patterns may be discerned.

Transitional monetary authorities

The transitional monetary authority, as its name implies, is intended as a stage in the metamorphosis of the currency board into the full-fledged central bank. While given more duties and powers than the currency board, its functions are less extensive than those of a typical central bank, and its operations subject to both government direction and legal restriction.

This circumscription of its role is in direct response to its environment. To economize on limited human resources, the institution concentrates on certain key functions—the basic operational tasks of issuing currency, banking for the government and commercial banks, and managing foreign exchange reserves. It will generally be less concerned with commercial bank supervision, especially where the banking system is dominated by foreign-owned banks, and with policy advice to the government. Indeed, the finance ministry often plays an important part in the monetary authority’s operations, confirming, if not originating, key policy decisions. Policy coordination may be sought by giving the finance ministry representation on the board of the monetary authority and by giving the minister the constitutional right to override any decision the board makes. Allocating responsibility for policy in this way is feasible, given a concentration of monetary policy on the medium term rather than the short term; only relatively routine matters need to be dealt with on a day-to-day basis.

But the credibility of the transitional body would be threatened if the public were to believe that the government could abuse its influence over fiduciary issue. For this reason, legal constraints are usually imposed on the monetary authorities’ operational powers. Commonly observed safeguards include a foreign exchange cover requirement and a limit on holding of government liabilities. The cover requirement constrains the monetary authority to hold foreign exchange reserves to at least a certain percentage of its demand liabilities. Thus, when the authority is overextended, it must acquire foreign exchange before domestic credit can be expanded further. In practice, most authorities hold considerable “excess” reserves to maintain short-term flexibility to issue currency in case of need. But while this cover requirement clearly restricts the absolute amount of government liabilities the monetary authority may hold, it does not prevent it from holding an excessive proportion of government debt relative to its other assets. To prevent this happening, most countries impose further restrictions on the volume and duration of the monetary authority’s lending to government.

The most clear-cut examples of such transitional arrangements are the “monetary authorities” established in the 1970s in small former British colonies: the Central Monetary Authority of Fiji (founded in 1973), the Solomon Islands Monetary Authority (1976), the Monetary Authority of Seychelles (1976), the Belize Monetary Authority (1978), and the Maldives Monetary Authority (1981). In these countries, the title “Monetary Authority” was chosen deliberately to suggest that the new institutions were not expected to carry out all the functions or to have the operational independence of a full-fledged central bank immediately. In fact, many so-called Central Banks in developing countries have similar limits on powers and responsibilities. Of course, in practice, transitional monetary authorities range from newly founded bodies that still function virtually as currency boards to more mature institutions that carry out most of the activities of a central bank: the range of activities tends to be gradually extended as the new authority gains operational experience and confidence in its judgments. So, for example, the two newest Monetary Authorities, in Belize and the Maldives, undertake only a limited range of functions, while at the other end of the spectrum the Central Monetary Authority of Fiji may now be classified as a true central bank. Although formally the Ministry of Finance’s approval is still mandatory prior to many of its actions, the Fiji Authority has been fully involved in the formulation and execution of monetary policy, using a wide range of interest rate and credit control instruments.

Monetary unions

The usual rationale for a country to form a monetary union with a group of others is that such a union promises potential gains from (1) improved intraregional allocation of resources as exchange risk is eliminated (or at least reduced) and internal barriers to the flow of funds removed, and (2) reduced overall need for foreign exchange reserves as balance of payments risks are pooled and intraregional transactions conducted in a regional currency. On the other hand, a country’s monetary policies have to be subordinate to the common regional policy; national sovereignty is lost in the formulation of policy on domestic credit expansion, interest rates, and exchange restrictions. But in a developing country this may prove to be an advantage as it implies a greater measure of independence from individual government pressures.

Two alternative institutional bases for monetary unions in small developing countries are the regional central bank and the currency enclave.

The regional central bank carries out all the functions of a central bank—but for a group of countries, each of which may have an equal but limited role in influencing policy. Consolidating the central banking functions of many countries leads to organizational economies of scale and reduces the demands made on each country’s human resources. Giving the regional central bank responsibility for overall direction of monetary policy and, in particular, for setting national limits on credit expansion reduces the influence of any particular government on policy formulation. The independence of the regional central bank may be protected by statutory restrictions on its operations with the member governments.

The West African Monetary Union provides perhaps the best working example of a monetary union with a regional central bank. It comprises six former French West African colonies: Benin, the Ivory Coast, Niger, Senegal, Togo, and Upper Volta. The regional central bank, the Banque Centrale des Etats de 1’Afrique de 1’Ouest (BCEAO), has headquarters in Dakar and agencies in each country. The headquarters is responsible for the formulation of policy and the management of foreign exchange reserves; the agencies conduct local operations, which include issuing the common currency, acting as banker to the banks and government, and supervising the financial system. The total amount of rediscounting available to commercial banks in each country is determined centrally; the national authorities may influence the allocation of this total among different domestic uses, subject to a statutory limit on credit to the government. All members except Senegal adhere to a common set of banking regulations, with uniform prudential ratios set by the BCEAO. In practice, the BCEAO has been able to achieve a considerable independence in its determination of policy that the authorities of other unions—such as the Central African Monetary Union and the East Caribbean Currency Area—have so far been unable to match.

Currency enclaves

A second option for countries seeking a monetary union is to form a currency enclave with a much larger and more developed partner—as, for example, Liberia has with the United States. In Liberia, the U.S. dollar is legal tender and the domestic financial system is dominated by U.S. commercial banks. Indeed, until 1974, Liberia’s central banking functions were carried out by the Bank of Monrovia, a branch of Citibank. In 1974, the National Bank of Liberia was established but to this day its currency issue is restricted to the supply of coinage. The National Bank takes responsibility for supplying U.S. dollars to the system, but its operations are strictly constrained by the reserves that it obtains as prudential deposits from domestic commercial banks, trade, and foreign borrowing. In the absence of controls on capital mobility, domestic financial conditions are determined more by financial conditions in the United States and by the attitudes of foreign banks to Liberian borrowers than by domestic monetary policy.

A more elaborate arrangement transfers responsibility for monetary stability in the enclave to the partner, leaving the monetary authorities of the enclave to carry out banking and regulatory functions. For example, in the Rand Monetary Area—consisting of Lesotho, Swaziland, and South Africa—the Basuto and Swazi authorities may issue their own currency to circulate in tandem with the South African rand but must back such issue with deposits with the Reserve Bank of South Africa. The Reserve Bank has agreed in return to function as lender of last resort in the two enclave countries.

Extremely open economies

Where the authorities have decided that economic development is best served by removing restrictions on capital as well as trade flows, monetary policy must play a passive role. In fact, any attempt to manipulate domestic credit conditions could, in these circumstances, threaten not only the stability of the financial system but also, in consequence, the whole growth strategy. To maintain confidence that such events will not occur, the monetary authorities may be tightly bound by constitutional restrictions—to curb the possibility of pernicious political influence as much as to guard against central banking incompetence. The focus of the monetary authorities may then be directed much more toward the regulation and promotion of the financial system, often with an eye to establishing it as at least a regional financial center and an earner of foreign exchange. To achieve this requires a careful balance between enforcing well-advertised standards of behavior and flexibility in setting these standards to encourage vigorous but prudential financial activity.

Singapore is a country that since independence has followed successfully such a route of monetary conservatism combined with financial entrepreneurship. Currency issue is still in the hands of a currency board, effectively imposing a 100 per cent cover requirement, while there is no government lending. There is a separate Monetary Authority responsible for banking and regulating functions, which has been closely involved in the development of Singapore’s “financial supermarket.” Recently, Chile has undertaken a reform of its own central banking institutions designed to achieve similar ends. The Central Bank of Chile must now operate under a 100 per cent cover requirement and may not lend to the Government, while extensive controls on capital flows are slowly being dismantled.

Does it all matter?

It could be argued that what really counts in the final analysis in determining monetary policy is not the legal framework of central banking but the balance of power between the government and monetary authority and the personal relationships involved. Legislation on its own may not be enough to guarantee prudent behavior, for it is not clear that central banking laws are actually enforceable, especially when they are flexible and vague. Certainly, there are cases in which rules have been altered expediently or merely waived. But perhaps rules do have at least symbolic importance in establishing confidence in a new monetary order in the early stages of a transition, especially if the transition involves the introduction of a new national currency. Similarly, it may well be that dropping apparently ineffective constraints on fiduciary issue or lending to government might create the expectation that the authorities did, in fact, intend to violate one or the other. Even if the rules in force served no useful purpose, removing them might nevertheless have an undesirable destabilizing effect on the system.

On the other hand, the organization established by legislation probably plays a more positive role. Operating procedures, channels of communication, and lines of command all play some part in determining where and how decisions are actually made. Such seemingly mundane matters as rights of access and powers of appointment may ultimately be more important than the more grandiose objectives and powers enshrined in the central banking legislation. The balance of power between government and monetary authority depends not only on personalities and outside support but also on the institutional framework in which their relations are established. Otherwise much less concern would be paid to the design of central banking institutions than there is throughout the world—from an emerging nation such as Bhutan now setting up its very first monetary authority to the United States where relations between the Federal Reserve Board and the Executive have been the source of continuing controversy.

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