Occasional Papers of the International Monetary Fund

*1. International Capital Markets: Recent Developments and Short-Term Prospects, by a Staff Team Headed by R.C. Williams, Exchange and Trade Relations Department. 1980. 2. Economic Stabilization and Growth in , by Hans O. Schmitt. 1981. *3. External Indebtedness of Developing Countries, by a Staff Team Headed by Bahram Nowzad and Richard C. Williams. 1981. *4. World Economic Outlook: A Survey by the Staff of the International Monetary Fund. 1981. 5. Trade Policy Developments in Industrial Countries, by S.J. Anjaria, Z. Iqbal, L.L. Perez, and W.S. Tseng. 1981. 6. The Multilateral System of Payments: Keynes, Convertibility, and the International Monetary Fund's Articles of Agreement, by Joseph Gold. 1981. 7. International Capital Markets: Recent Developments and Short-Term Prospects, 1981, by a Staff Team Headed by Richard C. Williams, with G.G. Johnson. 1981. 8. Taxation in Sub-Saharan Africa. Part I: Policy and Administration in Sub-Saharan Africa, by Carlos A. Aguirre, Peter S. Griffith, and M. Zuhtu Yucelik. Part II: A Statistical Evaluation of Taxation in Sub-Saharan Africa, by Vito Tanzi. 1981. 9. World Economic Outlook: A Survey by the Staff of the International Monetary Fund. 1982. 10. International Comparisons of Government Expenditure, by Alan A. Tait and Peter S. Heller. 1982. 11. Payments Arrangements and the Expansion of Trade in Eastern and Southern Africa, by Shailendra J. Anjaria, Sena Eken, and John F. Laker. 1982. 12. Effects of Slowdown in Industrial Countries on Growth in Non-Oil Developing Countries, by Morris Goldstein and Mohsin S. Khan. 1982. 13. Currency Convertibility in the Economic Community of West African States, by John B. McLenaghan, Saleh M. Nsouli, and Klaus-Walter Riechel. 1982. 14. International Capital Markets: Developments and Prospects, 1982, by a Staff Team Headed by Richard C. Williams, with G.G. Johnson. 1982. 15. : An Economic Survey, by a Staff Team Headed by Patrick de Fontenay. 1982. 16. Developments in International Trade Policy, by S.J. Anjaria, Z. Iqbal, N. Kirmani, and L.L. Perez. 1982. 17. Aspects of the International Banking Safety Net, by G.G. Johnson, with Richard K. Abrams. 1983. 18. Oil Exporters' Economic Development in an Interdependent World, by Jahangir Amuzegar. 1983. 19. The European Monetary System: The Experience, 1979-82, by Horst Ungerer, with Owen Evans and Peter Nyberg. 1983. 20. Alternatives to the Central in the Developing World, by Charles Collyns. 1983. 21. World Economic Outlook: A Survey by the Staff of the International Monetary Fund. 1983.

*Out of print

(Continued on inside back cover)

©International Monetary Fund. Not for Redistribution Occasional Paper No. 20

Alternatives to the Central Bank in the Developing World

By Charles Collyns

International Monetary Fund Washington, D.C. July 1983

©International Monetary Fund. Not for Redistribution International Standard Serial Number: ISSN 0251-6365

Reprinted July 1984

Price: US$5.00 (US$3.00 to university libraries, faculty members, and students)

Address orders to: External Relations Department, Attention Publications International Monetary Fund, Washington, D.C. 20431

©International Monetary Fund. Not for Redistribution Contents

Page

Prefatory Note v

I. Introduction 1

II. The Rationale for Central 2 Why Central Banking Institutions? Why Central Banks?

III. The Role of Central Banking in Developing Countries 5 The Objectives of Monetary Policy Financial Structure and Monetary Operations Social and Political Constraints on Central Banking

IV. The Transitional Central Banking Institution 10 Fiji and Bhutan

V. The Supranational Central Bank 13 The West African Monetary Union and the Central African Monetary Area East Caribbean Currency Authority

VI. The Central Banking Institution in a Currency Enclave 16 Liberia and Panama The Rand Monetary Area and France d'outre-mer

VII. The Central Banking Institution in an Extremely Open Economy 18 and Kong Kuwait, , and the United Arab Emirates

VIII. Conclusion 21

TABLE

Section

VIII. 1. Alternative Central Banking Institutions 22

REFERENCES 23

iii

©International Monetary Fund. Not for Redistribution The following symbols have been used throughout this paper:

to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;

- between years or months (e.g., 1979-81 or January-June) to indicate the years or months covered, including the beginning and ending years or months;

/ between years (e.g., 1980/81) to indicate a crop or fiscal (financial) year.

"Billion" means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

©International Monetary Fund. Not for Redistribution Prefatory Note

This study was prepared in the Central Banking Department by Charles Collyns. The author is grateful to his colleagues in the Central Banking Department, particu- larly Deena R. Khatkhate and Sergio Pereira Leite, for their advice and encourage- ment in the preparation of this paper. It was completed in November 1982 and does not deal with more recent developments of the organizations that it describes. Views expressed in the study are those of the author and do not necessarily represent the views of the Fund.

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©International Monetary Fund. Not for Redistribution This page intentionally left blank

©International Monetary Fund. Not for Redistribution I Introduction

A national central bank is usually high on the shopping rency enclave central banking institution," and the list of a newly independent country. Such a country often "open economy central banking institution." The "cur- inherits a currency board—a carryover from the colonial rency board" is a further example of a central banking era—and wishes to establish a new monetary authority institution. It should be noted that the title of an institu- with far wider executive powers and public responsibili- tion need not be an accurate guide to that institution's ties. Although the principal motives for acquiring such characteristics: central banks may exist in name but not an institution may well be profit and prestige, central nature, and vice versa. banking consists of much more than printing money and The plan of this paper is as follows: Section II provides attending international conferences. Central banks in a brief analysis of the rationale for the various central developed countries typically conduct a broad array of banking activities and for their establishment in a single, banking, regulatory, and supervisory functions. In a operationally independent institution within the general developing country, however, the problems and opportu- context of the developed world. Section III gives a broad nities facing the monetary authority may be radically dif- picture of the particular problems and opportunities fac- ferent from those encountered in the developed world. In ing central banking institutions in developing countries. recognition of this fact, not all of these countries have It focuses on the scope for monetary policy in a relatively chosen to set up a full-fledged central bank: many have small, specialized economy, on the links between mone- preferred alternative institutional arrangements. While tary operations and the domestic financial structure, and inevitably a number of common formulas have been on social and political constraints on the monetary applied in designing such new forms of monetary author- authorities' actions. Together these two sections provide ity, central banking legislation has generally been the analytical background to the survey of alternative adapted to fit national needs, capabilities, and aspira- institutions that follows. Each of Sections IV-VII opens tions, while the practical execution of a blueprint has with a general discussion that attempts to characterize a often been gradual and idiosyncratic. The result is a wide particular class of central banking institutions as a partic- range of central banking institutions and a correspond- ular response to a certain set of problems and opportuni- ing variety of objectives, constitutional powers, policy ties, and goes on to describe actual examples of monetary instruments, and relations with central governments. authorities that, at least in some respects, correspond to This paper surveys the alternative institutional forms that the polar form. Section IV examines transitional central have emerged and seeks to explain the observed diversity banking institutions that are intended to provide stepping of experience. stones between the currency board or some other rudimen- Some definitions are useful at the outset. The term tary institution and the full-fledged central bank. Section "central bank" is used in this paper to refer to an institu- V discusses examples of monetary unions in which respon- tion bearing the full panoply of executive powers and sibilities for central banking in a group of countries are public responsibilities that is usually implied by that delegated to a single supranational institution. Section VI name; this generic sense is clarified in Section II of this is concerned with the alternative forms of monetary paper. The terms "central banking institution" and authority possible in countries in which the dominant "monetary authority" are used here synonymously to means of transaction is a foreign currency, and where refer to institutions that undertake responsibility for any responsibility for at least some central banking activities of the functions characteristic of the central bank or for maybe transferred to an external agency. Section VII deals any other activity involving the management or regula- with central banking institutions in extremely open econo- tion of some aspect of the financial sector of the economy mies in which most, if not all, restrictions on trade and in the public interest. Various generic types of central capital flows have been removed and in which the financial banking institutions will be described in Sections IV-VII sector is itself a focus of economic growth. Section VIII of this paper, including the "transitional central banking concludes the paper. institution," the "supranational central bank," the "cur-

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©International Monetary Fund. Not for Redistribution II The Rationale for Central Banks

Central banks in the developed world are given a wide cally proceed in two stages. First, it is necessary to range of public responsibilities and endowed with a corre- explain why it may be advantageous for certain activities spondingly broad array of executive powers. The activities of in a financial system to be performed by institutions with these institutions can be grouped into five general functions: explicit public responsibility rather than left to the mar- ketplace. Second, one needs to argue that these functions Currency issue and management of foreign reserves should be entrusted to a single centralized authority Provision of a national currency involves the physical which is discrete from, rather than an integral part of, the production and distribution of notes and coins, operations government. This section provides such a rationale for a in foreign exchange markets to guide the currency's rates central bank within the general context of a typical devel- of exchange with other currencies, and the management of oped country; it presupposes a country with a complex the reserves of foreign assets held to sustain the national economy, a sophisticated financial system, and a well- currency's external value. educated population. The role of banker to the government This function involves providing bank deposit and bor- Why Central Banking Institutions? rowing facilities to the government and acting as fiscal agent and underwriter for the government. It also includes All of the functions described above are intended to giving technical advice to the government on monetary contribute to the efficiency and stability of a financial sys- policy and financial affairs. tem that is conducive to overall economic prosperity. Reasons may be given to believe that in each case the The role of banker to domestic commercial banks function would be more effectively performed by a pub- This function normally includes the acceptance of licly responsible body than by private institutions seeking deposits to act as prudential reserves for these banks, the their own ends. willingness to discount commercial and government paper Regarding currency issue, money ideally serves as a for these banks, and the commitment to act as lender of convenient means of exchange, as a secure store of liquid- last resort to these banks. It may also involve the provision ity, and as a stable unit of account. The provision of a of central clearance facilities for interbank transactions. national fiat currency allows the seigniorage 1 obtained from currency issue to accrue to the home country. In The regulation of domestic financial institutions theory, each domestic commercial bank could be permit- This activity involves ensuring that commercial banks ted to issue its own currency without the home country and other financial institutions conduct their forfeiting the advantage of seigniorage. Indeed, it may be on a sound, prudential basis and according to the various argued that it would be appropriate to give commercial laws and regulations in force. It includes the monitoring of banks the right of fiduciary issue; this would permit mar- reserve ratio requirements and the supervision of banking ket forces to act to ensure the efficient provision of cur- conduct. rency.2 Under such an arrangement a person's desire to hold a particular bank's currency would depend on the The operation of monetary and credit policy convenience of use of that currency and on the stability of This function involves the manipulation of monetary its exchange value. Banks would earn seigniorage to the and credit policy instruments in seeking to achieve the extent that their own currency possessed these properties. government's chosen macroeconomic strategy and/or con- stitutionally mandated objectives. This task may require 1Seigniorage is used in the broad sense to refer to the pecuniary benefit actions to influence monetary aggregates, exchange derived from the issue of notes and coins as noninterest-bearing liabili- ties rather than in the narrow sense of the excess of the monetary over the rates, interest rates, and the distribution of credit. bullion value of coinage. A satisfactory rationale for central banks must logi- 2See, for example, Hayek (1976).

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©International Monetary Fund. Not for Redistribution Why Central Banks?

One flaw in this argument lies in the economies of scale policy intervention to speed adjustment to external inherent in the production of and, crucially, the use of shocks to the economic system even if financial markets fiat money. There would be a strong tendency for one pri- were both competitive and stable. The key issue is then vate currency to dominate the rest because of the reduced whether the costs and uncertainties involved in such transactions costs associated with the use of a common action in practice do not outweigh the potential benefits. currency, which would be immediately recognizable, While many economists believe that countercyclical inter- readily disposable, and the unit of account. However, vention can be effective in certain circumstances, others once such a monopolistic position were established, the are more skeptical, and would argue that monetary policy discipline of the market would no longer constrain the should be primarily concerned with the preservation issuer of currency to be efficient. (or restoration) of a stable and predictable monetary The position of banker to the government is a powerful environment. one. It is clearly important for the government to have access to specialized financial expertise untainted by the Why Central Banks? influence of any outside interest. In addition, the govern- ment's typical scale and central position in the economy Central banks are organizations that fulfill two crite- would require that its banker take due account of its ria: (1) they undertake most of the functions ascribed impact on the economy, particularly in decisions on how above to central banking institutions (at least acting as far to the government's credit requirements. issuer of currency, banker to the government, and banker The functions of banker to domestic commercial banks to commercial banks); and (2) they exercise considerable and of regulator of these banks' behavior are closely discretion in the choice of the means if not the objectives linked. These activities are directed toward two basic of their operations. objectives. The first is to safeguard the stability of indi- The benefits of establishing many of the central bank- vidual banks. Without central regulation, bank cus- ing functions within a single entity are easily explained. tomers could face considerable problems in ascertaining First, there are economies of scale to be gained from the relative security offered by different banks' services. entrusting these functions to one organization that may The imposition of reserve ratio requirements and the develop a considerable body of financial knowledge and supervision of banking conduct are intended to ensure expertise. Second, the close links between the functions that the supervised financial bodies all maintain a certain make it advantageous to establish a single body, with standard of security, on which their customers may then wide-ranging powers of investigation and execution, to be rely.3 At the same time, individual bank stability contrib- held responsible for the overall functioning of the finan- utes to the stability of the financial system as a whole. cial system. In practice, the range of functions under- Problems may arise when individual banks within the sys- taken by central banks does vary even between developed tem are heavily indebted to each other. Then the fate of a countries, but the functions that are sometimes incorpo- particular bank may have repercussions throughout the rated in separate institutions are usually specialized financial system that individual lenders fail to take into ones—such as the physical production of currency, the account. Central provision of lender-of-last-resort and provision of deposit insurance, and the licensing of finan- discounting facilities can recognize these repercussions cial institutions—that are not central to the operational and, hence, reduce the chances of bank failure spreading task of financial management. through the system. The reasons for the typical operational independence Aspects of each of these broad functions—in particu- of the central banking institution are again mainly practi- lar, the issuing of currency, the holding of government cal ones. Clearly, for the central banking institution to debt, the setting of reserve requirements, and the stance make rapid and flexible responses to a fluid financial of the lender of last resort—have strong implications for environment, it must have at least day-to-day operational the exchange rate, domestic conditions and independence. It is true that such limited independence the availability of credit, and hence for economic activity. would not preclude the central banking institution being, The use of monetary policy to influence macroeconomic for example, merely another section of the finance minis- conditions is, of course, a highly controversial and widely try; but independence from the finance ministry may be debated topic. To simplify, most economists would prob- desired as a check and a balance to that ministry in the ably accept that if domestic labor and product markets analysis and formulation of economic policy. Even so, were not fully competitive and responded slowly to shifts such independence would not be incompatible with the of the economic environment, there would be scope for central banking institution being embodied, for example, in a separate ministry of monetary affairs whose minister sat in the cabinet. However, a clear separation from the 3 With a system of deposit insurance in place to protect depositors, government altogether would make it easier for the cen- regulation would still be required to ensure that banks attained the mini- mum standard of security necessary to ensure the viability of the insur- tral banking institution to establish close links with the ance scheme; see Giddy (1982). financial community.

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©International Monetary Fund. Not for Redistribution II • THE RATIONALE FOR CENTRAL BANKS

A more controversial issue is the question of whether In practice, the central banking institution's degree of the central banking institution should be subject, in the independence from government does vary considerably last resort, to the decisions of the central executive office even within the developed world.5 The constitutionally of government. The orthodox view would be that mone- guaranteed independence from the executive of the Fed- tary policy, as an important lever of power, should ulti- eral Reserve Board and the Deutsche Bundesbank may mately be subject to democratic sanction; while the cen- be contrasted with the Bank of England's customary tral banking institution may be given a separate voice in independence in the operation of monetary policy but not policy debate, the final voice should belong to the repre- in the selection of goals and with the close supervision sentative government. The opposing view would empha- experienced by the Bank of France. It should be noted size that monetary policy—like the administration of that both the and the Federal Republic of justice—must be able to resist undue political pressures. have federal political structures in which con- It can be argued, for example, that central banking insti- stituent states provide a counterweight to the central gov- tutions should be constitutionally mandated to seek the ernment. Also, independence de facto would depend, at long-run objective of monetary stability on the grounds least in part, on the personalities of the senior politicians, that permitting political guidance of policy objectives civil servants, and central bankers involved and on the sup- would inevitably lead to policy actions designed to port each group would receive from the banking estab- achieve short-run advantages to the ultimate detriment of lishment and elsewhere. the economy. Such arguments hinge on the view that the Central banks could be classified by assessing (1) their electorate itself would be shortsighted in exercising its involvement in the execution of each of the tasks specified choice of government and on the economic theory that above, and (2) the degree of independence exercised in only unanticipated monetary policy would provide an the execution of each of these tasks. For the present pur- effective instrument to manipulate domestic output and 4 poses, it is sufficient to concentrate on an ideal or arche- employment. But even if it were to be determined that typal "full-fledged central bank" that is characterized as full independence would be desirable in principle, it being fully involved in each of the five typical functions of would still be necessary to establish an institution that the central banking institution and also as having consid- would indeed be capable of standing against both politi- erable, if not complete, discretionary powers to under- cal and popular pressures. take these functions.

4For a neat if simplistic illustration of such an argument, see Kydland 5For a survey of the degrees of independence exercised by central and Prescott (1977). banks in 16 developed countries, see Fair (1979).

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©International Monetary Fund. Not for Redistribution III The Role of Central Banking in Developing Countries

The discussion of Section II presupposed a complex industrial countries. However, consider a small, open economy, a sophisticated financial system, and a well- economy that exports a high percentage of output at a educated population. The situation in a developing coun- price substantially independent of the level of exports and try when it chooses its central banking institution may be whose import prices are fixed irrespective of desired vol- very different. Its economy may be dominated by a lim- umes; its terms of trade can be taken as given. In such an ited range of exports and faced by terms of trade beyond economy, production and real income are mainly influ- domestic control. Its financial system may be rudimen- enced by the costs of domestic supply and by world rather tary, based on foreign-owned commercial banks financ- than domestic demand conditions. In this situation, a ing commerce and export industries, an informal credit monetary injection that boosted domestic spending might network serving much of the rural economy, and an increase prices and output of nontraded goods and ser- inherited central banking institution which is essentially vices, but the multiplier effect would be limited by the a currency board. Its population may be short of workers small size of this sector of the economy. Inevitably the trained in the technicalities of finance and relatively unso- policy shift would result in balance of payments deficits phisticated in appreciating the economic realities of a situ- and loss of reserves (if the exchange rate were fixed) or ation. In these circumstances, an overriding consideration general (if the exchange rate were allowed to must be to ensure that the new monetary authority will be float). In general, the greater is the openness of the econ- able to establish credibility as a responsible and effective omy, the more difficult it is to affect the real economy body that is capable of instilling domestic and foreign con- through active monetary policy. fidence in the domestic currency and financial system. At There are both developed and developing countries the same time, it must be accepted that the new institution which may be characterized as having small, open econo- cannot hope to undertake immediately all of the functions mies. In developing countries, a high degree of export of the full-fledged central bank, while the scope for central specialization may leave the economy particularly vulner- banking activities would be considerably different from able to such exogenous shocks as fluctuations in domestic that in a more . supply conditions or in prices in world markets. But, This section takes up three topics in turn. First, it con- while the potential benefits of countercyclical action may siders the role for monetary policy in a small, developing be substantial in such conditions, such policy is likely to economy, arguing that the objectives of monetary policy be inherently costly and difficult to execute. The loss of in such an economy must be less ambitious than in a reserves and the inflation associated with a reflation larger, industrial economy. Next, it analyzes how various would have a particularly severe impact in a developing characteristics of the financial structure in developing country. Moreover, attempts at fine tuning would be countries affect the constraints and opportunities facing fraught with problems of control. Information and the central banking institution. Lastly, it considers how response lags between the first moments of a downturn the social and political environment may limit the capa- and the impact of the policy response would be lengthy, bilities of the central banking institution. while the links between policy instruments and domestic output would be tenuous and uncertain. In these circum- stances, it would seem desirable to place the focus of sta- The Objectives of Monetary Policy bilization on the finance of those particularly affected by a shock, rather than on any attempt to offset contraction In Section II, the rationale for an active monetary pol- in one sector by expansion elsewhere. Such a policy must, icy was linked to uncompetitive and slowly adjusting however, be cautious if the authorities find it difficult to domestic product and factor markets. In economies domi- distinguish between temporary shocks, for which a nated by such markets, the level of domestic demand degree of purely financial stabilization may be appropri- would play a key role in determining the levels of output ate, and permanent shifts in the trading environment, and employment. Such economies are typical of the large, which would require eventual real economic adjustment.

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©International Monetary Fund. Not for Redistribution III • THE ROLE OF CENTRAL BANKING IN DEVELOPING COUNTRIES

Given the difficulties involved in short-run stabiliza- been directed toward such policies, however, based on tion, the main thrust of monetary policy may be better skepticism over whether the market is really transmitting directed toward establishing the financial conditions inappropriate signals and over whether credit controls are required by the long-run development strategy of the truly effective or lead merely to a rerouting of funds from economy. In particular, in developing economies that other sources. have opted for export-oriented growth based on free trade The extent to which the monetary authority can influ- and the judicious encouragement of private enterprise, it ence domestic interest rates and credit conditions is usually advantageous to achieve a stable exchange rate depends on the access residents can obtain to interna- regime with commitments to maintaining the converti- tional capital markets and on the strength of preferences bility of the currency and to minimizing restrictions on for domestic as opposed to foreign-currency denominated capital flows. To maintain confidence in such a system, assets and liabilities. If residents were able to deposit and monetary policy must be broadly compatible with a borrow freely abroad at given world interest rates, and domestic inflation rate that is close to the world inflation were indifferent to the denomination of currency, then rate and with a current account deficit that is consistent the attempt to establish independent domestic rates with sustainable capital inflows. An inflation rate higher would not be sustainable and monetary policy would have than generally prevailing in competing countries would to be passive. In practice, domestic wealth holders do lead to a progressive loss of competitiveness, while a per- have a certain preference for domestic deposits because sistent balance of payments deficit would lead to rapidly of their convenience and lack of exchange risk. The diminishing foreign exchange reserves. Both of these stronger is this preference, the less interest elastic the effects would lead to expectations of an eventual devalua- demand for domestic deposits is likely to be. Moreover, tion and the imposition of a less liberal exchange control controls on outward capital mobility may be effective at regime. increasing the scope for monetary policy if they succeed A rate of domestic inflation above world levels and an in raising the costs of obtaining foreign deposits; they unsustainable balance of payments deficit are both symp- cannnot be completely watertight, however, for in an tomatic of high levels of expenditure relative to income open economy there will always remain many loopholes or, equivalently, to the expansion of domestic credit at a available to sophisticated opponents to evade restric- greater rate than the growth in demand for domestic tions. At the same time, foreign lenders will wish to limit financial assets. The relative importance of cash and the value of their loans to any particular developing coun- bank deposits in developing country financial sectors try: risks of default, costs of rescheduling, lack of local implies that the objective of financial stability requires information and foreign exposure regulations all act to close coordination between the expansion of domestic reduce the price elasticity of domestic access to foreign 7 bank credit and the growth in demand for monetary credit. The less is the elasticity of this access, the more assets. Short-run discrepancies between the two may be the monetary authority will be able to influence the price permitted for the sake of financial stabilization, espe- and availability of credit to domestic borrowers by vary- cially if official external funding can be obtained (for ing its own lending operations. example from the export earnings stabilization facility of In economies with extensive restrictions on trade and the European Community or from the International payments, domestic conditions will often be heavily depen- Monetary Fund's compensatory financing facility). But, in dent on the authorities' actions. Typically, such economies general, financial prudence would require that care be have maintained overvalued exchange rates. In these cir- taken to guide growth of the money supply and domestic cumstances, scarce foreign exchange is conserved by limit- 6 credit in accord with well-chosen targets. These targets ing the issue of import licenses or by implementing should be aligned with the development strategy, so as to exchange restrictions. In the latter case, the central bank- be compatible with the growth of domestic savings and the ing function of management of foreign exchange reserves expansion of domestic credit required for the national acquires a new aspect, that of rationing these resources in investment program. accordance with perceived national priorities. In addition, the authorities may seek to guide the alloca- tion of credit in accordance with development priorities rather than permitting commercial banks and other finan- Financial Structure and Monetary Operations cial institutions to place their loans as they see fit. Such policies are often motivated by the belief that market fail- The financial structure of a small, developing country ures distort private incentives away from their socially opti- tends to be fairly simple. Typically, the banking system is mal levels and would lead to misallocation of investment in dominated by several foreign-owned commercial banks, the absence of selective credit controls. Much criticism has

7Extreme smallness of a country does not by itself guarantee perfectly 6See Coats (1980) for similar arguments in favor of monetary targeting price-elastic access to foreign credit because each country's debt is effec- in developing countries. tively differentiated from others by its sovereign risk.

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©International Monetary Fund. Not for Redistribution Financial Structure and Monetary Operations which are branches of multinational banks rather than investment, and the interest rate spread necessary for locally incorporated. Indigenous enterprises are usually bank profitability. To escape such a situation, the mone- either owned by the government or on a relatively small tary authorities may need to adopt an entrepreneurial scale. Many of these smaller-scale enterprises, especially in role in encouraging institutional innovation.8 Domestic rural areas, would be part of an informal credit network saving may be accelerated by setting up new financial and outside the purview of the monetary authorities. institutions—such as credit unions, provident funds, and In such a context, the instruments available for the unit trusts—that offer attractive alternatives to the bank application of monetary policy are considerably restricted. account and the hoarding of cash. Such institutions may In more developed financial systems, central banks are able require subsidization in their early years, given the infra- to exercise close control over domestic interest rates or over structural economies of scale which deter private initia- the availability of domestic credit through the manipulation tive. Private holding of government securities and com- of discount rates, through open market operations, and mercial paper may be promoted by reducing restrictions through intervention in money markets. The influence of on access and by market intervention designed to reduce these instruments depends on commercial banks being sen- price fluctuations; both of these actions would enhance sitive to changing domestic credit conditions or at least mak- the liquidity of these assets. On the credit side, lending ing conventional responses to policy shifts. These responses for socially desirable investments may be increased by may be weak or even absent altogether in a financial struc- establishing a development bank capable of thorough ture in which the dominant foreign-owned banks tend (1) to project assessment and the disbursement of interest rate be relatively liquid, (2) to prefer to resort to parent banks subsidies. Commercial lending to small-scale and rural rather than to a central banking institution for temporary enterprises may be encouraged by providing credit guar- credit, and (3) to set interest rates with oligopolistic inflexi- antees and legal safeguards that would reduce the costs of bility. Moreover, open market operations and intervention default. in money markets are unsuitable instruments for policy At the other extreme, some countries have adopted intervention if the markets for government securities and sophisticated programs aimed at establishing their finan- short-term commercial paper are shallow; in such circum- cial sectors as international centers earning foreign stances, price responses would tend to be volatile and exchange through the export of . In such unpredictable. In addition, induced fluctuations in finan- situations, the authorities' role must be directed toward cial prices would, by increasing the uncertainty of returns in achieving an appropriate balance between the policing of these markets, reduce the liquidity of financial assets, and well-advertised standards of behavior that ensure confi- so act to discourage would-be participants. The result would dence in the probity of the domestic institutions and flexi- be to repress the rate of development of these markets. bility in setting these standards so as to promote vigorous Monetary policy in developing countries is usually con- market responses to shifting external opportunities. In ducted by more direct means. Often the central banking many such cases, a sharp distinction is drawn between institution is given powers to regulate commercial banks' the onshore financial system, which trades in local cur- deposit and lending rates directly and to issue credit rency, and the offshore market, which is based on instru- guidelines and ceilings. The central banking institution ments denominated in an international currency. Unless may also influence bank liquidity by manipulating pru- this distinction is preserved by strict controls on trans- dential reserve ratios and by controlling its extension of actions between the two sectors, domestic conditions credit to banks and to the government. By use of these would tend to be dominated by the external financial instruments, policy may be equally capable of influenc- environment. ing domestic monetary conditions in the medium to long The requirements of the lender of last resort and of the run as via discount rate or open market operations. bank supervisor in small, developing countries will However, these policy instruments would be less well depend on the prevailing financial structure and on equipped for day-to-day control for two reasons. First, ambitions for reform. These functions will often be response lags must inevitably be permitted before insist- undertaken by parent banks to the extent that domestic ing on compliance. Second, coercion or moral suasion as banks are foreign owned. Parent banks are likely to opposed to price incentives cannot be applied too fre- monitor the branch's operations, to offer financial exper- quently or the system of control would be placed under tise, and to provide short-term credit to the branch in a excessive strain. crisis—and indeed will often be better equipped to fulfill Another factor is that the attainment of monetary tar- these functions than would the domestic authorities—in gets consistent with a country's development plan may order to maintain the parent bank's international reputa- require more policy intervention than the manipulation tion for sound management. In such circumstances, the of interest rates or the direction of domestic credit. For domestic authorities would retain an important licensing example, there may be a fundamental incompatibility function—the denial of entry to international banks that between the deposit rates needed to generate the required saving, the lending rates required to induce planned 8See Bhatt (1974).

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©International Monetary Fund. Not for Redistribution III • THE ROLE OF CENTRAL BANKING IN DEVELOPING COUNTRIES

do not achieve high standards—but need be less con- on human resources may limit the extent to which the cen- cerned with supervising day-to-day operations. Neverthe- tral banking institution can involve itself in certain activi- less, the supervision of foreign exchange, interest rate, ties, particularly ones requiring both technical expertise and credit control regulations may be particularly neces- and intensity of application—such as banking supervision sary in order to guard against the possibility that the few and economic research to guide policy selection. foreign branch banks might take undue advantage of An equally important but more controversial issue is their oligopolistic position in the domestic market.9 the question of how to ensure that the central banking On the other hand, in other countries, active regula- institution plays an appropriate role in policy selection. tory and financial support would be essential if the The arguments used in Section II to support the indepen- authorities sought to promote indigenous financial enter- dence of the central banking institution are, perhaps, prises as a primary objective. Local institutions would be particularly applicable in a developing country. Third initially at a considerable competitive disadvantage in World governments have often succumbed to the tempta- being unable to trade on a parent bank's reputation. tion to use rapid monetary expansion to finance short- Moreover, bank failure would have a particularly unde- term gains that are dissipated in subsequent inflation (or, sirable impact, not so much directly as interrelations in extreme cases, hyperinflation). However, even if between banks may be small in scale, but rather through desired, it is difficult to guarantee the independence of a strong detrimental effect on attitudes toward indige- any central banking institution, and especially one in a nous financial institutions in general. Confidence in the developing country. This independence may have been domestic financial system may be bolstered by the exis- achieved in certain developed countries that have consti- tence of a lender of last resort and by provision of deposit tutionally enshrined the central bank's freedom of action insurance facilities. But these activities could be prohibi- to seek specific objectives. These countries also usually tively costly without sufficiently close supervision of bank possess established financial communities that would operations to ensure prudent financial behavior. In a sit- provide firm support for policies aimed at the attainment uation with low standards of domestic accounting tech- of monetary stability. niques and inadequacies of information, such supervision In developing countries, independence de jure may would require considerable commitment of central bank well not be sufficient to ensure independence de facto. resources. For one thing, the local financial community may be either unable or unwilling to provide much assistance to bolster a central banking institution whose policy inten- tions conflicted with the government's wishes. Indige- Social and Political Constraints on Central nous financial institutions might be too poorly estab- Banking lished or too closely related to the government by either personal ties or dependence on government favors. One obvious constraint on the central banking institu- Foreign-owned banks, meanwhile, would be reluctant to tion of a small, developing country is a shortage of indige become closely involved in domestic political issues. nous personnel who have the training and experience to Without the support of a powerful ally, the central bank- conduct its . Often the former central banking ing institution may be susceptible to political influence. If institution, such as, for example, a currency board, will the executive board of the central banking institution have carried out largely mechanical functions and have tried to resist the government's wishes, the government provided few opportunities for staff to develop opera- could respond by using its powers of dismissal and appoint- tional skills or financial acumen. The senior managers of ment to obtain a more sympathetic set of decision makers. the foreign-owned banks will tend to be expatriate and in These powers would be weakened if they were hedged by limited supply; they may well be reluctant to leave the pri- legislation that lengthened terms of appointment and estab- vate sector and, in any case, may be regarded with some lished proper judiciary procedures for dismissal. The gov- suspicion by the government. Foreign experts may be ernment might, nevertheless, be able to bring sufficient imported but may lack local knowledge and contacts, informal pressure to bear to ensure that even a nominally may be expensive to hire, 10 and would probably be unwill- independent central banking institution would set its policy ing to make a long-term commitment. Thus, a constraint in accordance with government wishes. A variety of means has been used in the attempt to bol-

9 ster the independence of monetary policy; indeed each of A common feature of an unregulated oligopolistic banking structure the four basic alternatives to the central bank to be dis- is a form of financial repression in which banks choose to set deposit interest rates low, often implying negative real returns, and opt for a cussed in Sections IV-VII employs a distinctive approach conservative lending policy. Such a strategy tends to lead to slow growth to this problem. Essentially, however, these different of financial intermediation, but to ensure steady profits. methods are all permutations on two basic devices. The 10Limited numbers of experts may be supplied at subsidized costs by technical assistance programs run by, for example, the Central Banking first is to include directions to or constraints on policy Department of the International Monetary Fund. selection in the legislation establishing the central bank-

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©International Monetary Fund. Not for Redistribution Social and Political Constraints on Central Banking ing institution, with the intention that the setting of limits The second device is to transfer a measure of responsi- on the discretionary powers of the central banking insti- bility for monetary policy decisions to an external body, tution would also serve to reduce the ability of the govern- such as a central banking institution shared with other ment to impose its own will on monetary policy. Selection countries or even belonging solely to another country, of such an approach would presuppose a decision that the that would be able to resist home government pressures appropriate form of monetary policy would be largely more successfully. Such an arrangement would typically nondiscretionary, and could only be successful if consti- involve joining a monetary union, which would place con- tutional and other safeguards were sufficient to prevent straints on monetary policy and require the acceptance of the relaxation of the legal restrictions when convenient. foreign involvement in domestic affairs.

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©International Monetary Fund. Not for Redistribution IV The Transitional Central Banking Institution

The transitional central banking institution, as its intensive and in part redundant if the banking system is name implies, can be seen as a stepping stone in the dominated by foreign-owned banks. transformation of a country's monetary authorities from Additional economies in manpower may be obtained a colonial currency board to a full-fledged central bank. by confining responsibility for the analysis and formula- The typical currency board issued domestic currency for tion of monetary policy to the finance ministry, leaving foreign exchange and offered limited banking facilities to the central banking institution in charge of operational commercial banks. It did not have the power of fiduciary matters. The government would be granted an explicit issue; it did not conduct monetary policy or even provide right to override any decision of the central banking insti- policy advice; it was not committed to acting as lender of tution, while policy coordination may be ensured by giv- last resort; it did not supervise the banking system or ing the finance ministry representation on the monetary impose any prudential reserve requirements. Its basis lay authority's board. This division of responsibility would in a financial system dominated by commercial banks be feasible given the inevitable concentration of monetary originating in the colonial power, which were expected to policy on the medium rather than the short run; only rela- be able to mind their own branches, and in a commit- tively routine matters would need to be dealt with on a ment to a fixed parity with the colonial power's currency, day-to-day basis. which implied a passive monetary policy. The primary A substantial degree of government control might raison d'etre for the currency board lay in capturing the threaten the credibility of the financial system, however, if seigniorage benefits of currency issue for the colony itself. the public were to believe that the government was likely to The external value of the currency was guaranteed by the misuse its influence over fiduciary issue. To bolster confi- requirement, implicit in the process of currency issue, dence, legal constraints are typically imposed on the oper- that the currency be backed 100 percent by foreign ations of the transitional central banking institution. Two exchange reserves. such safeguards are commonly observed, usually in combi- In contrast, the transitional central banking institution nation: a foreign exchange reserve cover requirement and typically conducts a wider range of activities than the cur- a limit on the central banking institution's holding of gov- rency board, at least acting as banker to the government ernment liabilities. and to the central bank, and possesses greater powers, As mentioned above, the currency board was effec- including those of fiduciary issue and often bank inspec- tively required to hold 100 percent cover for domestic cur- tion. Nevertheless, the functions it undertakes are rency issued. Transitional central banking institutions restricted to a narrower range than would be usual for a tend instead to be constrained to hold foreign exchange central bank, and its operations are often subject to both reserves to at least a certain percentage of their demand government direction and legal restriction. These charac- liabilities. This formulation reflects the role of the transi- teristics may be viewed as direct responses to the circum- tional central banking institution as a deposit-accepting stances in which the central banking institution must institution; in this role, reserve money does not only con- function in a newly independent, small, developing country. sist of currency issue but also includes bank deposits with The transitional central banking institution econo- the monetary authority. Expressed in either form, the mizes its use of limited human resources by concentrating requirement imposes a legal limit on the fiduciary issue of workers in certain key functions to the neglect of others. the central banking institution.11 When the constraint The basic operational tasks of issuing currency, accept- binds, the monetary authority may not increase domestic ing deposits, making loans, and managing foreign liquidity by extending domestic credit only but must, in exchange reserves may well absorb a high proportion of the technical expertise available. Unless promotion of 11 Whether a requirement that the central banking institution hold indigenous banks is a high priority for financial policy, say, 50 percent backing for its demand liabilities is more or less stringent than a requirement that it hold 100 percent cover for currency issue commercial bank supervision provides a good candidate depends on the relative demand for currency and deposits in the econ- for a relatively low level of involvement, being both skill omy in question.

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©International Monetary Fund. Not for Redistribution Fiji addition, acquire foreign exchange. In practice, central authorities that carry out most of the activities of the full- banking institutions would normally aim to operate fledged central bank. within the boundary to maintain flexibility in fiduciary issue in the short term. It is also common for the central banking legislation to include a clause allowing tempo- Fiji rary relaxation of the rule with the finance minister's con- sent—although such a clause might partially circumvent The case of Fiji provides a good example of the gradual the purpose of the constraint. evolution of a transitional central banking institution While the cover requirement clearly restricts the cen- within a single basic legislative framework. The Central tral banking institution's absolute ability to hold govern- Monetary Authority of Fiji (CMA) has been operating for ment liabilities, it does not prevent it from concentrating a decade and over this period has accumulated consider- a high proportion of its assets into holdings of govern- able reserves of technical expertise. It now conducts a ment debt. The cover requirement is typically supple- wide range of activities and is involved in most aspects of mented by two separate restrictions on such holdings, the financial system, which is itself relatively sophisti- often imposed together. The first would limit the purpose cated relative to Fiji's small size and simple economic for which advances to the government could be extended structure. The economy is dominated by the performance to the finance of temporary deficiencies in current of the two major exports, sugar and tourism, and is com- budgetary revenue; these loans must usually be repaid paratively open to both trade and capital flows. within a short period after the end of the financial year. The CMA is endowed with the sole right of fiduciary The second would limit the central banking institution's issue of the currency, the Fiji dollar, but is restricted by overall holding of government debt, including treasury statute to hold external reserves worth at least 50 percent bills and long-term securities as well as loans. This limit of its demand liabilities and to seek the Minister of may be expressed as a percentage of the government's Finance's approval for changes in parity. In practice, the own average annual revenue over a preceding period or as CMA has held external reserves at least 100 percent in a percentage of the central banking institution's total excess of the statutory minimum, even in the seasonal demand liabilities. trough of low foreign exchange receipts, but this has not The most clear-cut examples of the transitional central prevented foreign exchange reserves from falling at times banking institution are provided by a series of so-called to low levels in terms of months of imports: the need for a "Monetary Authorities" set up over the last decade in sustainable balance of payments rather than any statu- countries which, with one exception, were formerly Brit- tory obligations has proven to be the dominant constraint ish colonies: the Central Monetary Authority of Fiji on fiduciary issue. The CMA also exercises discretion (founded in 1973), the Solomon Islands Monetary over the rates of exchange for the Fiji dollar; these are set Authority (1976), the Seychelles Monetary Authority each week to fix the Fiji dollar's value against a weighted (1976), the Monetary Authority of Belize (1978), the Mal- basket of currencies of trading partners. This system dives Monetary Authority (1981), and the Royal Mone- replaces the simple fixed sterling peg anticipated in the tary Authority of Bhutan (1982). In these cases, the title legislation. "Monetary Authority" was selected deliberately to sug- As banker to the government, the CMA is authorized gest that the new institutions were not expected imme- to grant advances to the government to meet temporary diately either to carry out all the functions or to have deficiencies in currency revenue, subject to repayment the operational independence of a full-fledged central within the six months following the end of the , 12 bank. In practice, many other central banking institu- and to hold securities and other debt instruments of the tions in developing countries would be better categorized government, provided that the total value of these does as transitional central banking institutions than as cen- not exceed 30 percent of the average annual ordinary tral banks—despite being called "Central Banks." revenue of the government. In fact, the government has A substantial uniformity in the legislation establishing been, for the most part, a net depositor with the CMA; these transitional central banking institutions should not total borrowing has never exceeded 50 percent of the obscure a considerable diversity of behavior within the maximum allowed. This observation remains true when category. The legislation provides the transitional central public sector corporations, which are also permitted to banking institution with responsibilities and executive bank with the CMA, are included in the analysis. In the powers which may be taken up only slowly; a spectrum past, the Fiji Sugar Corporation in particular, with its may be observed from the one extreme of authorities that strongly seasonal pattern of receipts and expenditures, function virtually as currency boards to the other of has made extensive use of this facility; but it is now encouraged to deal directly with commercial banks. Fiji's banking system consists of five foreign-owned 12The title was first applied to the Monetary Authority of Singapore commercial banks and the publicly owned National Bank. (see Section VII). Banking legislation requires the former set of banks

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©International Monetary Fund. Not for Redistribution IV • THE TRANSITIONAL CENTRAL BANKING INSTITUTION to obey cash reserve and government security ratio require- bank inspection, and the inclusion of the National Bank ments set by the CMA and, in return, the CMA offers under the CMA's aegis. lender-of-last-resort facilities. These banks have usually amply exceeded reserve requirements, although the excess fulfillment has tended to fall over time as alternative uses Maldives and Bhutan for funds have developed. In response, the CMA has attempted to restrain the rising ratio of loans to deposits In the newest transitional central banking institutions, through moral suasion, but without complete success. in Maldives and Bhutan, the authorities are still much Banks have taken only intermittent recourse to CMA lend- concerned with establishing the national currency as the ing, preferring in general to borrow from the parent bank dominant form of money, a prerequisite to the practice of or on the expanding interbank money market. In addition an independent monetary policy. In Maldives, U.S. dol- to reserve requirements, banks must obey interest rate, lars—introduced into the economy through tourism—cir- credit allocation, and various other guidelines issued by culate alongside the local currency, the rufiyaa, while the CMA subject to government approval. The basis of time and savings deposits and loans may be denominated regulation lies in close liaison with the CMA in regular in either of the two currencies. The amount of dollars in meetings, rather than a formal inspection which is only circulation cannot be measured accurately, making it dif- authorized at times of crisis. ficult to monitor developments in domestic liquidity. In addition to the six commercial banks, Fiji possesses Moreover, the possibility of dollar deposit and loan a unit trust, a stock exchange, a development bank, an accounts would complicate the application of any interest insurance , and a credit union movement. The rate policy intended to separate domestic from world CMA is involved in the management and regulation of rates. Recent policy, adopted after measures relying on these in its efforts to promote the development of the voluntary surrender had proved ineffective, has been to financial system. Particular duties include the underwrit- proscribe the use of dollars and other foreign currencies ing of bonds issued by the development bank and the as means of payments. In Bhutan, where the bulk of for- supervision of the insurance industry, a function that has eign trade is conducted across an open border with India, been recently transferred from the Ministry of Finance. the predominant currency in circulation is the Indian Despite Fiji's openness, the CMA has been able to fol- rupee, although all bank accounts and contracts are low an active and independent monetary policy, using the denominated in the national currency, the ngultrum. The various instruments at its disposal. In general, regulated Royal Monetary Authority aims to administer a gradual interest rates have been kept low relative to world rates, increase in the role of the ngultrum over time, so as not to although not so noticeably low relative to rates ruling in disturb local confidence in its parity with the rupee. neighboring and . This policy is While this shift may be fairly simply accomplished in the supported by limits on the domestic borrowing of foreign interior, the use of rupees seems likely to be more persis- firms and on outward capital flows. The overall strategy tent in border areas given the local importance of trade is guided by a monetary budget planning procedure in transactions. which the CMA has played an important part; its Gen- Among the first tasks of the authorities in both Mal- eral Manager currently acts as chairman of the main dives and Bhutan has been to assume responsibility for policy-making committee while its Research Department foreign exchange management from various government has been closely involved in forecasting exercises. and other agencies. In Bhutan, matters are complicated In sum, although the CMA still has the form of the by the fact that the bulk of the country's net foreign assets transitional central banking institution, its operations are held in rupee deposits by the country's single com- are becoming sufficiently extensive and discretionary to mercial bank, the Bank of Bhutan. The Bank of Bhutan warrant it the classification of central bank. At present, is jointly owned by the Government and the State Bank of legislation is being considered to formalize this de facto India, which offers the Bank of Bhutan a preferential independence and to amend the original legislation where return on rupee deposits. For the Royal Monetary appropriate. In particular, contemplated measures include Authority to fulfill the function of foreign exchange man- the transfer of responsibility for monetary policy decisions agement effectively, it must obtain satisfactory terms for from the government to the CMA to simplify cumbersome its own rupee deposits, and be able to manage the busi- administrative machinery, the strengthening of powers of ness requirements of foreign exchange transactions.

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©International Monetary Fund. Not for Redistribution V The Supranational Central Bank

This section discusses the supranational central bank, would have a pernicious influence on policy formulation. which may be characterized as carrying out all the func- Admittedly, the necessity of uniform regional interest tions of the central bank, but for a group of countries rates might still be a drawback to such an arrangement. joined in monetary union rather than for a single country The costs attached to this uniformity would depend on alone. Such an institution would consist of a central the disparities existing between the economic situations headquarters, in which broad policy decisions would be in the different member countries of the union. taken, and separate agencies in each country undertak- Three examples of monetary unions with suprana- ing operational tasks. Each member country would have tional central banking institutions, drawn from Africa an equal but limited role in influencing overall policy, but and the Caribbean, are discussed in this section. All three a stronger influence over operations with mainly domes- arrangements originated in colonial monetary integra- tic significance. tion, but central banking activities have been greatly The characteristic features of a monetary union extended since independence, particularly in the African include: (1) a common currency (or at least a set of freely cases. In the Caribbean example, the supranational interconvertible currencies); (2) compatible external authority still bears many features of the transitional cen- exchange restrictions; (3) minimal constraints on internal tral banking institution. capital mobility; and (4) a coordinating institution hold- ing a common set of exchange reserves. The usual "opti- mal currency area" rationale for the formation of a The West African Monetary Union and monetary union runs in terms of the advantages to be the Central African Monetary Area gained from the improvement of the intraregional alloca- tion of resources, as exchange risk is eliminated (or at The West African Monetary Union and the Central least reduced) and internal barriers to the flow of funds African Monetary Area are the two standard examples of are removed, and from the reduction of the overall need monetary unions with regional central banks. Their con- for foreign exchange reserves, as balance of payments stituent countries were formerly French colonies partici- risks are pooled and intraregional transactions are con- pating in the Franc Zone with the local currency, the ducted in a regional currency. On the other hand, mem- CFA franc, being issued by two regional instituts d'emis- bership of a monetary union requires that national mone- sion.14 Following independence, these countries chose to tary policies be subordinate to the common regional remain within the Franc Zone but, at the same time, to policy. National sovereignty is lost in the formulation of broaden the regional institutional framework. They policy on domestic credit expansion, interest rates, and established supranational central banks, which were pro- 13 exchange restrictions. vided with substantial autonomous powers although still In a developing country, however, two additional subject to French influence. Local control was strength- advantages may be obtained by joining a monetary union ened further in reforms of both systems in the early and ceding sovereignty over monetary policy to a regional 1970s. central bank. First, the centralization of the central The West African Monetary Union (WAMU) is now banking functions of many countries within a single unit formed by Benin, Ivory Coast, Niger, Senegal, Togo, and leads to organizational economies of scale and reduces Upper Volta. The Union continues to use the CFA franc the demands made on each country's human resources. as the common currency and sets no controls on capital Second, giving the supranational central bank responsi- mobility within the Franc Zone; each country imposes its bility for the overall direction of national monetary pol- own particular exchange and trade restrictions. The icy, and, in particular, for setting national limits on supranational central bank, the Banque Centrale des credit expansion, lowers the danger that a government 14The institut d'emission in a French colony served the same basic role 13See the discussion in Nsouli (1981). as the currency board in a British one.

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©International Monetary Fund. Not for Redistribution V • THE SUPRANATIONAL CENTRAL BANK

Etats de l'Afrique de l'Ouest (BCEAO), has headquar- over commercial bank refinancing and the setting of the ters in Senegal and agencies in each country. The head- interest rates in the money market. In the past, these quarters is responsible for the formulation of policy and instruments have not proven sufficient to prevent overrun the management of the common pool of foreign exchange of targets, and recently they have been augmented by reserves; the agencies conduct local operations. Each direct ceilings on commercial bank lending. Bank country also has a National Credit Committee and is rep- deposit and lending rates can only be altered with the resented on the Council of Ministers which oversees the approval of the Council of Ministers and are adjusted system and bears primary responsibility for membership infrequently to prevent the emergence of excessive differ- and managerial appointments. entials between rates ruling in WAMU and elsewhere in CFA francs are issued on demand by the agencies of the Franc Zone. the BCEAO, at a fixed parity with the French franc guar- Monetary arrangements in the Central African Mone anteed by the French Treasury. In return for this guaran- tary Area (CAMA)—consisting of Cameroon, the Central tee, the BCEAO holds an operations account with the African Republic, Chad, Congo, and Gabon—are for- French Treasury and must deposit at least 65 percent of mally similar to those in the WAMU. The main sub- its nonoperational reserves with the Treasury; the French stantive contrasts lie in the greater degree of national provide compensation to the BCEAO for any decline in sovereignty exercised within the CAMA, and the corre- the value of these reserves against a chosen index—cur- spondingly more subordinate role played by its central rently the special drawing right. The BCEAO undertakes bank, the Banque des Etats de l'Afrique Centrale to replenish the operations account when necessary from (BEAC). For example, banking legislation differs its non-franc reserve holdings, and to raise domestic between each member of the CAMA and is enforced by rediscount rates and reduce rediscount ceilings should national bodies rather than the BEAC, while deposit and the average value of net foreign assets fall below 20 per- lending rates are not set uniformly. Control over refi- cent of the BCEAO's demand liabilities for three consec- nancing is the main instrument of monetary policy- utive months. there is as yet no interbank money market—but credit The BCEAO acts as banker to each of the member gov- ceilings are applied flexibly. Overall targets are estab- ernments, subject to the restriction that total gross credit lished by the National Monetary Committees, rather than to any government must be less than 20 percent of its tax by the BEAC, while no constraints are applied to the refi- receipts in the previous year. Credit to the government nancing of agricultural loans and export credits. Essen- may take the form of short-term advances, holding of tially, credit policy has accommodated demand and has long-term securities, and the rediscounting of commer- been sustained by the region's strong oil-based balance of cial bank credit to government: all three are subject to the payments position. same overall credit limit. The dominant feature of the BCEAO's relations with commercial banks is its refinancing of commercial bank East Caribbean Currency Authority credit. Refinancing is provided, at the authorities' discre- tion, for up to 35 percent of a bank's total credit; a pref- The East Caribbean Currency Authority (ECCA) was erential rate is available for lending to agriculture, small- set up in 1965 following the dissolution of the British Car- scale construction, and small to medium-sized locally ibbean Currency Board. Its seven member countries— owned businesses. The BCEAO also organizes an inter- Antigua and Barbuda, Dominica, Grenada, Montserrat, bank money market which provides a mechanism for the St. Kitts-Nevis-Anguilla, St. Lucia, and St. Vincent and transfer of funds between banks and between countries the Grenadines—are small island economies.15 These within the WAMU. Commercial banks hold deposits countries are also linked in the Caribbean Common Mar- with the BCEAO, but do not face specific reserve require- ket and the Organization of East Caribbean States, ments although foreign deposits are limited to working which are intended to establish a uniform trade policy deposits. Banking regulations are uniform in all coun- and promote regional development and integration. tries except Senegal, and adherence to the regulations is There are no controls on capital movements within the supervised by the BCEAO. East Caribbean area, but external policy, lying outside Monetary policy in the WAMU is determined jointly by ECCA jurisdiction, is not fully coordinated: tariffs are the BCEAO and the National Credit Committees. A uniform across countries in theory, but tend to be diverse credit budget is formulated for each country, taking into in practice due to national divergences in application; account national and regional considerations, with the indirect and foreign exchange purchase taxes vary BCEAO bearing responsibility for the national credit tar- between countries; and exchange controls are enforced gets and the National Credit Committees having respon- with differing degrees of strictness. sibility for the allocation of credit between different uses within the national limit. The main instruments available 15The relatively large neighbor, Barbados, withdrew from the cur- to the BCEAO to execute the resulting plan are its control rency agreement in 1974 to establish its own independent central bank.

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©International Monetary Fund. Not for Redistribution East Caribbean Currency Authority

The principal functions of the ECCA have been the offers rediscounting facilities, but these have not been issue of the common currency, the East Caribbean dollar, utilized: commercial banks in each country have been liq- and the management of the foreign exchange reserves. uid and are generally unwilling to extend local credit The East Caribbean dollar is at present pegged to the beyond local deposit resources. Thus, political problems U.S. dollar; a change in parity requires the unanimous that might be triggered if savings in one member country approval of member governments. The ECCA converts flowed into investment in another are avoided. the East Caribbean dollar into foreign exchange on At present, the ECCA itself has no regulatory responsi- demand for the commercial banks and has no prior right bilities or powers; it imposes neither reserve restrictions to foreign exchange earnings. It is required to maintain nor controls on interest rates or credit allocation. Com- the value of its foreign reserve cover to at least 60 percent mercial banks do, however, receive directions from host of its demand liabilities and has generally operated with a governments to hold deposits with the ministry of finance substantial reserve cushion. or to hold certain proportions of their deposit liabilities in The 60 percent cover requirement acts as an overall government paper; these requirements usually depend on constraint on ECCA lending to member governments. In government financing needs rather than being designed addition, the ECCA's statutes restrict its holding of trea- to support any particular monetary policy. Foreign- sury bills issued by any member government to 10 percent owned banks are also subject to the dictates of their par- of that government's estimated annual recurrent revenue, ent banks. In practice, these banks have opted for con- and its combined holding of other securities of member servative policies, with low (often negative, in real terms) governments to 15 percent of the ECCA's demand liabili- deposit rates and relatively high interest spreads, which ties. In practice, the ECCA estimates the total permitted have led to moderate rates of growth of assets but secure availability of loanable funds each year and allocates bor- profits. rowing rights to each member government in proportion to Given its limited array of powers, the ECCA has little the government's estimated revenues. Not all member scope for the exercise of monetary policy. Its organization countries draw down their full quotas, and the ECCA has combines features of the transitional monetary authority in the past retained leeway to extend additional temporary with those of the supranational central bank to curtail credit to governments facing emergency conditions. government's ability to sustain deficit finance. Govern- The banking system in the ECCA member countries is ments seeking funds in excess of the ECCA's lending tar- dominated by branches of foreign banks. The main ser- gets must face the discipline of external capital markets, vice provided by the ECCA to the banking system lies in while internal adjustment policies rely mainly on fiscal the operation of a central clearing house for interbank policy for stabilization purposes. The decision has now payments. Participating banks are required to hold a been made to convert the ECCA into a central bank more minimum balance of noninterest-bearing call deposits akin to the BCEAO and the BEAC. This new institution with the ECCA and may be granted short-term overdraft is to be endowed with statutory rights to impose reserve facilities. The ECCA also accepts time deposits, paying requirements on commercial banks, to set interest rate rates of interest designed to induce banks to deposit minima and maxima, and to regulate the availability of funds with the ECCA rather than overseas. Although money and credit. The 60 percent foreign cover require- rates are slightly lower than available elsewhere and the ment and government lending limitations are to remain ECCA applies no minimum liquid reserve regulations, in force, but the new provisions will permit relaxation of foreign branch banks are generally willing to earn good- these limits with the unanimous approval of member will by placing deposits with the ECCA. The ECCA also governments.

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©International Monetary Fund. Not for Redistribution VI The Central Banking Institution in a Currency Enclave

In a currency enclave, the currency of a typically larger In both of these countries, foreign-owned commercial and more developed foreign country circulates alongside, banks dominate the financial systems, which are open to or in some cases in place of, the domestic issue. This situ- unrestricted current and capital transactions.16 In Libe- ation has arisen where extensive and unregulated trade ria, the central banking institution is the National Bank of with a dominant partner, predating the establishment of Liberia, which was established in 1974 to take over the a national currency, has led to the customary acceptance central banking functions previously conducted by the of the partner's currency as a means of transaction. With Bank of Monrovia (a subsidiary of Citibank)—including such a high degree of financial openness, domestic inter- the provision of banking services to the commercial banks est rates and credit conditions in the enclave are strongly and to the government—and to initiate bank supervision. influenced by monetary conditions in the partner. More- In Panama, central banking responsibilities are shared over, in this context, powers of fiduciary issue would be between the National Banking Commission and the particularly limited as the domestic currency (often con- National Bank of Panama. The former is in charge of fined to coinage) may have only restricted acceptability as bank supervision and is concerned with the promotion of a means of transaction. In addition, if local contracts are Panama as an international financial center. The latter is denominated in the foreign currency, shifts in exchange a commercial bank, although in part publicly owned. In rate parity do not alter relative prices. For all these rea- addition to its regular commercial banking activities, it sons, the scope for independent monetary policy in a cur- acts as banker to other commercial banks and as the fiscal rency enclave is particularly narrow, and the role of the agent of the government. It also plays the role of develop- domestic central banking institution may be limited. ment bank in undertaking higher-risk loans in the public The influence of central banking in the enclave may be interest, using aid receipts to subsidize interest charges. reinforced, however, by the actions of a monetary author- Both the National Banks of Liberia and Panama under- ity in the partner country. In particular, such an author- take to supply their respective financial systems with the ity would be likely to have greater ability to extend emer- U.S. dollar notes and local coinage required to meet the gency liquidity in a crisis. A cooperative arrangement domestic transactions demand for currency. could be feasible if the interests of the two countries were Despite the formal similarity in the monetary arrange- largely compatible and if the allocation of responsibility ments of these two countries, their individual experiences to the partner were politically acceptable. Indeed, such have been very different. In Panama, an environment of an arrangement might be preferred to the alternative of financial stability has fostered rapid growth of domestic extending the fiduciary powers of the currency enclave deposits, while the combination of political security, lib- central banking institution on the grounds that an exter- eral banking legislation, and economic prosperity has nal agency would be less susceptible to undue internal helped to establish the country as an important offshore political pressures and have a more established record for banking center. By contrast, in Liberia, the financial sys- financial competence and prudence. tem has encountered serious difficulties in recent years, The case studies in this section include two countries, manifested in the contraction of the money supply and Liberia and Panama, which rely on the U.S. dollar as the private credit and the failure of a major bank. These principal form of money—domestic issue being restricted events have coincided with a deterioration in the external to coinage—but have no formal support agreement with balance as the Government has attempted to compensate the U.S. authorities. By way of contrast, the second two weakness in the export sector by increased public sector examples of enclaves, the Rand Monetary Area and activity. France d'outre-mer, have central banking institutions In the present context, it is important to note that the which are closely linked to authorities in the partner coun- Liberian authorities' limited powers of fiduciary issue tries. The earlier discussion of Bhutan and Maldives is have not screened the financial system from external also relevant in this context in describing countries that strains; rather, these strains have been revealed in an are making the transition from enclave to independent unusual fashion. Given the scarcity of foreign exchange, monetary area. the National Bank of Liberia has not always been able to fulfill its function of supplying dollar currency on demand Liberia and Panama 16Foreign exchange restrictions were introduced in Liberia in April 1980, in the aftermath of a change in the government, but were removed In Liberia and Panama, the U.S. dollar is legal tender the following month, after proving difficult to operate, partially ineffec- and the domestic issue of currency is confined to coinage. tive, and damaging to external confidence.

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©International Monetary Fund. Not for Redistribution The Rand Monetary Area and France d'outre-mer for internal transaction purposes; the limited supply the local monetary authorities obtain seigniorage from available to it from exporters, reserves, and external bor- currency issue, responsibility for ensuring monetary sta- rowing is mostly absorbed in payment for oil imports' and bility is shared with an extranational agency. in external debt service. So commercial banks are no In other respects, the Lesotho Monetary Authority and longer necessarily able to withdraw excess reserves from the Central Bank of Swaziland bear many similarities to the National Bank of Liberia in cash. While these banks the transitional central banking institutions discussed may receive some foreign exchange from client exporters, earlier. In common with the monetary authorities in Mal- they are not able to draw unlimited amounts on parent dives and Bhutan, both must be prudent but resourceful banks unwilling to increase their Liberian exposure. in promoting the gradual replacement of the foreign issue Moreover, the currency in circulation is regularly depleted by the domestic issue without threatening confidence in by direct deposit overseas. In consequence, cash bears a the new means of transaction. The Lesotho Monetary premium value against Liberian bank deposits, which Authority has, for example, maintained a noninterest- encourages commercial banks to compete for currency bearing rand deposit account with a commercial bank in and offshore resources rather than for deposits and loans. , which in its turn is willing to exchange the Indeed, banks may sometimes be unwilling to make pri- maloti for the rand at par; this arrangement is designed to vate loans that would require import finance or to cash or encourage banks and merchants in South African border accept as deposits checks drawn against other banks. This areas to do likewise, and so enhances the usefulness of the situation has led to an inefficient allocation of monetary maloti. In both countries, the monetary authorities have resources and high transactions costs. taken steps to centralize the management of foreign exchange reserves, but substantial holdings remain in the hands of the commercial banks (in Lesotho) and the gov- The Rand Monetary Area and ernment (in Swaziland). In Lesotho, in particular, the France d'outre-mer Government has continued to hold the bulk of its deposits with local commercial banks rather than with the mone- The Rand Monetary Area—consisting of Lesotho, tary authority; the Lesotho Monetary Authority has been South Africa, and Swaziland—was set up in 1974. It is important, however, in raising funds for the Government, based on the use of a common currency, the South African in acting as an intermediary with foreign banks, and in the rand, and provides for free transfer of funds within the placement of treasury bills, as well as being a substantial area, compatible exchange restrictions on the transfer of purchaser of government securities. In Swaziland, the funds outside the area, and the pooling of gold and foreign 17 Government has been a net creditor of the Central Bank of exchange reserves with the South African Reserve Bank. Swaziland and of the commercial banks. In both coun- Both Lesotho and Swaziland have subsequently estab- tries, the commercial banks, which are either govern- lished autonomous monetary authorities of their own: the ment-owned or foreign-owned, make deposits with the Lesotho Monetary Authority (founded in 1980) and the 18 monetary authorities which provide an important compo- Central Bank of Swaziland (1974). Under bilateral nent to the centralization of foreign exchange holdings; agreements with South Africa, the Lesotho and the Swazi recourse to lender-of-last-resort facilities and bank super- authorities are empowered to issue their own currencies, vision are both limited. Interest rates necessarily follow the maloti and the lilangeni, respectively, both valued at fluctuations in South African rates, and monetary policy par with the rand, to circulate as legal tender within their is in general passive. own borders. Their currency issue must, under the terms of these agreements, be completely covered by their hold- In France d'outre-mer, the ties between the external ings of rand currency, special interest-bearing deposits authority and the local monetary system are even closer. The Institut d'Emission in Paris takes direct responsibility with the South African Reserve Bank, and marketable for the monetary affairs of both the Departments (such as securities of the South African Government. The South Guiana, Martinique, and Reunion) and the Territories African Reserve Bank is given specific responsibility to act (such as French Polynesia and New Caledonia). Each of as lender of last resort in Lesotho and Swaziland through these Departments and Territories has its own currency but the temporary extension of credit to the Lesotho Monetary parity with the French franc is guaranteed by the Institut Authority and the Central Bank of Swaziland. So while d'Emission. The Institut d'Emission is particularly con- cerned with control of the volume and allocation of credit, 17Botswana was a founding member of the Rand Monetary Area, but which it achieves through its policy of rediscounting via subsequently withdrew when setting up its Central Bank. local agencies to commercial banks at prices dependent on 18The Central Bank of Swaziland was originally entitled the Monetary Authority of Swaziland. This institution's name was altered in 1979 the use of funds. The Institut d'Emission is itself subject to without substantial extension of its powers or responsibilities. the French Finance Ministry's supervision.

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©International Monetary Fund. Not for Redistribution The Central Banking Institution in an Extremely Open VII Economy

This section considers central banking institutions in tism and a stable political environment. Barriers to trade countries with market-oriented economies, open to both and to capital flows have been progressively removed; by trade and capital flows. As discussed in Section III, it may 1978 exchange controls had been completely dismantled. be very difficult in such countries to exert a strong influence Singapore has grown into a major financial center, and is on domestic interest rates or credit conditions. Moreover, now the largest external currency center in Asia. There are successful export-led growth depends on foreign confi- two main central banking institutions, the Board of Com- dence in the continuation of the liberal trade and payments missioners of Currency and the Monetary Authority of system and in the establishment of a stable monetary envi- Singapore, set up in 1967 and 1970, respectively; proposed ronment. To maintain such confidence, the central bank- legislation that would bring the former under the auspices ing institution must be financially prudent; it must hold of the latter has yet to be enacted. The Board of Commis- reserves, or at least have access to credit, sufficient to cover sioners of Currency operates as a strict currency board, normal fluctuations in demand for domestic currency, and controlling the issue of the Singapore dollar subject to hold- aim to restrict its own extension of credit to the increase in ing at least 100 percent foreign exchange reserve cover. The demand for its own liabilities. To provide some guarantee Monetary Authority of Singapore is responsible for the of such behavior, the central banking institution may be bulk of the central banking functions and has a wide range statutorily bound by restrictions on its fiduciary issue and of supervisory and regulatory powers. Recently, however, on its lending to government. the task of managing the country's foreign exchange port- A common feature of economies open to trade and capi- folio has been transferred to a separate body, the Singapore tal flows is that the financial sector is an important focus of Investment Corporation, which is intended to provide a growth, often being a major source of foreign exchange more aggressive approach to foreign investment. earnings. As noted in Section III, success in this field The monetary operations of the Monetary Authority of requires the central banking institution to play a carefully Singapore consist largely of recycling funds deposited by judged regulatory role, designed to enhance confidence the Government into the commercial banking system without stifling initiative. This active role contrasts with the through the rediscounting of bills and open market opera- more passive conduct of monetary policy. tions. In the past, the Monetary Authority of Singapore Examples of central banking institutions in an open attempted to influence domestic credit conditions in line economy are provided by Singapore, , Kuwait, with macroeconomic policy objectives. This policy was Saudi Arabia, and the United Arab Emirates. In Singa- bolstered by regulations intended to keep domestic and pore, the fiduciary powers of the central banking institu- offshore markets distinct. Since 1975, domestic deposit tions have been deliberately restricted but the regulatory and lending rates have been freely determined in the mar- powers of these institutions are extensive. In Hong Kong, ket and have followed the Singapore interbank rate, the monetary authorities have limited powers and finan- which in turn has followed the Asian dollar rate and, cial success has been achieved through almost unfettered hence, world financial conditions. The Monetary Author- entrepreneurship. Finally, in the oil exporting Gulf ity of Singapore has, for the most part, kept the rediscount states, the strong fiscal position has led to a shift in re- and the treasury bill rates in line with these market rates, sponsibilities between the central banking institution and recognizing that a policy aimed at setting independent the government. interest rates could not be sustained for long, given the ready domestic access allowed to international capital markets. After a period in which the Monetary Authority Singapore and Hong Kong of Singapore attempted to steer domestic monetary aggre- gates along a target path, the current policy seeks to stabi- Since gaining independence, Singapore has combined lize the exchange value of the Singapore dollar. This strat- an export-oriented development policy with fiscal conserva- egy is believed to be a more effective means to control

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©International Monetary Fund. Not for Redistribution Kuwait, Saudi Arabia, and the United Arab Emirates

inflation in a highly open economy, and is conducted to take a less prominent part in guiding the evolution of through swap operations in the foreign exchange market. the financial system and in supervising foreign branch The regulatory functions of the Monetary Authority of banks. Singapore are directed at the promotion of the Singapore financial system. Entry into this system is limited by tiered licensing, which allows less than half of registered banks Kuwait, Saudi Arabia, and the United Arab to conduct the full range of banking operations; other Emirates banks hold "restricted" or "offshore" licenses. The Mon- etary Authority of Singapore imposes a series of liquidity The economies of Kuwait, Saudi Arabia, and the requirements on banks and finance houses, issues direc- United Arab Emirates fall into a distinctly different cate- tives guiding their lending operations, and controls their gory of open economy than those of Hong Kong or Singa- nonbanking activities. It has also been instrumental in pore. They are dominated by exports of oil, which provide encouraging the development and diversification of the the countries with considerable world market power to Asian dollar market. Not only are offshore operations influence their terms of trade. A basic feature of their released from liquidity requirements and eligible for con- rapid development over the last decade has been the rap- siderable tax benefits, but, in addition, the Monetary idly increasing deployment of government oil revenues Authority has been fully involved in setting up offshore into domestic investment. Financial sectors have grown markets for bonds, certificates of deposit, and commer- with the accumulation of financial wealth and the rising cial paper. requirements for internal financial intermediation, and The experience of Singapore may be contrasted with have been encouraged by governments seeking focuses for that of Hong Kong. The economy of Hong Kong is very diversification. Access to world capital markets is effec- similar to Singapore's, but the former's colonial adminis- tively good: there are few restrictions on financial flows, tration has been much less involved in financial affairs. while the substantial stocks of both financial assets and oil Indeed, in Hong Kong, currency issue is performed by the reserves imply that marginal shifts in net lending cannot two foremost commercial banks, the Hong Kong and much affect these countries' aggregate net worth or Shanghai Bank and the Chartered Bank, which also act as threaten their credit rating. lender of last resort, serve as banker to the government, Kuwait and the United Arab Emirates both have Cen- and administer the interbank clearance mechanism. The tral Banks; Saudi Arabia, a Monetary Agency. These range of functions entrusted to public institutions is lim- monetary authorities are legally entrusted with the issue of ited and divided. The Commissioners of Banking and of currency, the roles of banker to commercial banks and Deposit-Taking Companies undertake the licensing, government, the regulation and promotion of the banking supervision, and regulation of banks and deposit-taking system, and the execution of monetary policy. companies, respectively. The Secretary for Monetary Of these roles, banking regulation is crucial to the Affairs takes responsibility for the management of official development of these countries as financial centers, espe- assets and liabilities, for the issue of coinage, for foreign cially as all three countries are intent on local ownership exchange operations, and for relations with international and management of their financial institutions. In the monetary institutions. United Arab Emirates, the Central Bank has only recently Official monetary policy in Hong Kong was purely displaced a currency board, endowed with little regulatory laissez-faire until the financial crisis in 1978. This crisis power, following a banking crisis arising from rapid followed excessively rapid credit creation by the banking financial expansion and speculation against the domestic cartel, leading to a collapse in the value of the Hong Kong currency. This new institution has applied a minimum dollar. Since then, the Commissioner of Banking and the restriction on the capitalization of domestic commercial Secretary for Monetary Affairs together have attempted to banks, and has required banks to accumulate out of their restrain the growth of domestic credit. Their influence has profits a reserve fund, the value of which should be at least been exerted primarily through moral suasion that 50 percent of capital. Commercial banks must provide the encourages domestic interest rates to follow world levels Central Bank with extensive information on their opera- more closely, in combination with closer supervision of tions and establish proper auditing facilities. The govern- financial operations. Neither open market operations nor ment intends to establish a separate Credit Risk Bureau discount rate manipulation are available in the absence of charged with monitoring local lending to support this either government securities or central bank lending. supervision. Kuwait and Saudi Arabia have also taken In Hong Kong, in strong contrast to Singapore, the steps to strengthen monitoring and enforcement proce- monetary authorities have never been much involved in dures. A particular problem now being faced in all three the promotion of the financial system. Even so, the finan- countries is set by the money changers, whose activities cial development of Hong Kong has proceeded at a rapid have extended beyond their eponymous role but have hith- pace. It is therefore interesting to observe the recent reor- erto been unregulated. The authorities are taking steps to ganization in Singapore, where the Monetary Authority is restrict licensing, to limit the range of activities under-

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©International Monetary Fund. Not for Redistribution VII • THE CENTRAL BANKING INSTITUTION IN AN EXTREMELY OPEN ECONOMY taken, and to establish proper monitoring facilities; but deposit rates. This action is consistent with Islamic law, whether such controls can be effective in a traditionally which prohibits interest payments, and also reflects a informal business sector remains to be proven. desire to encourage local investment. Narrow, even nega- In all three countries, the role of banker to the govern- tive, spreads between savings, deposit, and lending rates ment is relatively limited. Given the substantial budgetary are feasible for commercial banks receiving a high propor- surpluses, governments have not required loans from tion of deposits as noninterest-bearing demand deposits their bankers; rather, they must determine the allocation and having access to low-cost central bank credit. Saudi of their accumulated financial resources between central Arabia and the United Arab Emirates both impose ceil- bank deposits and other uses. In the United Arab Emir- ings on some deposit rates of interest. Given the minimal ates, deposits with the monetary authority claimed a par- controls on capital mobility, these policies have led ticularly small percentage of government assets in the domestic wealth holders to invest a substantial portion of past, although this proportion has now risen to around 50 their portfolios offshore, as well as in foreign currency- percent following the establishment of the Central Bank, denominated deposits with domestic banks bearing inter- as the individual emirates hold considerable foreign assets nationally competitive returns. In consequence, domestic on their own account. In Saudi Arabia, government finan- monetary aggregates do not fully reflect the total money cial resources are recycled into the domestic economy via balances held by residents. the five government-owned, specialized credit institutions An implication of these arrangements is that the gov- which provide long-term credit to priority sectors at highly ernments of these countries have more influence on concessional rates; the amount of this credit is, in fact, domestic credit conditions than do the monetary authori- about double the total of commercial bank funds made ties. It is up to the government to decide how much to available to the private sector. The Saudi Arabian Mone- deposit with the monetary authorities and the extent of tary Agency itself receives government deposits intended credit subsidies; these decisions determine how far the for investment abroad. In Kuwait, government funds monetary authorities and other specialized institutions reach the domestic economy at concessional rates both via can expand domestic credit and at what price. In addi- three specialized banks and via the combined intermedia- tion, the government domestic budget deficit, that is, gov- tion of the Central Bank of Kuwait and commercial ernment revenue from domestic sources less government banks—the Central Bank provides cheap rediscounting domestic expenditure, is the main source of increase in facilities to subsidize commercial bank lending, and is privately held wealth.19 To the extent that this wealth is itself financed by government deposits and subsidies. placed in domestic bank deposits rather than being spent In these countries, monetary policy has attempted to on imports or deposited abroad, it provides the commer- influence domestic financial conditions. The Central cial banks with funds to expand their own credit. Bank of Kuwait is empowered to limit the lending rates of domestic banks and has imposed low ceilings relative to those rates obtaining elsewhere and to uncontrolled 9See Morgan (1979).

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©International Monetary Fund. Not for Redistribution VIII Conclusion

This paper has discussed the operations of a wide range enclave is limited by the dominating influence of the mon- of central banking institutions in developing countries. It etary environment of the partner and by the discretionary has been observed that the public responsibilities and powers allocated to the latter's authorities. Finally, in an executive powers of these central banking institutions are economy open to both commodity and capital flows, the often less extensive than those normally associated with a monetary environment is subject to the dominating influ- central bank in a developed country, although develop- ence of world markets, and the central banking institution ment priorities may lead to the acquisition of special func- is usually closely involved in the regulation and promotion tions not found elsewhere. A variety of reasons have been of the domestic financial structure. suggested to explain why not all countries have full- Table 1 summarizes the characteristic features of these fledged central banks. The three central points were: four categories and of the currency board and the central bank by assessing each for (1) its involvement in the six Close integration of the domestic economy with inter- central banking functions (the five discussed in Section II national commodity and capital markets may restrict plus the promotion of financial development) and (2) the both the scope and the need for an independent mon- constraints placed on independence of policy selection etary policy. and execution. It should be apparent from the survey of The domestic financial structure may not be suffi- country experience provided in this paper, however, that ciently elaborate to support or require the full range the actual diversity of central banking institutions is not of central banking functions, but may justify special fully captured by this classification, and that, in practice, emphasis on particular regulatory and promotional a monetary authority often displays characteristics com- activities. bining features of more than one of the proposed polar The attempt to ensure a degree of independence of types. monetary policy from domestic political control may In the end, it may be asked how much the choice of involve legal constraints on central banking powers central banking institution really matters. It could be or the transfer of certain responsibilities to external argued that what counts in the final analysis is the balance agencies. of political power between the government and monetary The considerable diversity of economic, financial, and authority. On this view, the important factors influencing political conditions within the Third World has brought policy decisions would include the personalities of politi- forth a wide variety of central banking institutions. Four cians and senior officials, and the support each group polar types have been identified as providing coherent could draw from other sources; while the legal and organi- alternatives to the central bank. The transitional central zational framework within which decisions are made banking institution forms an intermediate step between would be largely irrelevant. currency board and central bank. Government typically Historical experience certainly indicates that legislation exerts a strong influence on the activities of the transi- on its own may not be enough to guarantee prudent behav- tional central banking institution, but this influence is ior. While many countries' central banking institutions checked by statutory limitations on the monetary author- have not yet come close to violating foreign exchange cover ity's discretionary powers. The supranational central requirements or restrictions on government lending, in bank is responsible for undertaking the central banking other cases the rules have simply been sidestepped by activities in a group of countries participating in a mone- technical adjustments, altered expediently, or merely tary union. The framework of joint decision taking ignored. The question arises as to whether such rules are restricts any individual government's influence over mon- actually enforceable, especially when expressed in a flexi- etary policy. In a currency enclave, central banking activi- ble and imprecise form. It seems likely that the prospect of ties may be shared between the domestic central banking a foreign exchange crisis would act as a more powerful institution of the developing country and a monetary deterrent to financial profligacy, and that the ultimate authority of the larger partner. Monetary policy in the discipline to monetary policy would lie in external limits

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©International Monetary Fund. Not for Redistribution VIII • CONCLUSION

Table 1. Alternative Central Banking Institutions Function Regulation Operation Promotion Banker to of of of Currency Banker to commercial financial monetary financial Institution issue government banks institutions policy development Full-fledged central bank 3 3 3 3 3G 1 Supranational central bank 3E 2E 2 2 2E 2 Open economy central banking institution 3C 2C 2 3 1 3 Transitional central banking institution 3CG 2C 2 1 2G 3 Currency enclave central banking institution 1,2CE 2CE 2 1 13 Currency board 3C 1 1 1 1 1 Key: 1 = limited involvement C = considerable constitutional restrictions 2 = substantial involvement E = considerable external influence 3 = full involvement G = considerable government influence on borrowing from world financial markets. Nevertheless, appointment, may ultimately be more relevant than the rules do have symbolic importance in establishing confi- more grandiose objectives and powers enshrined in the dence in the new monetary order in the early stages of a central banking legislation. The balance of power transition, and especially if the transition involves the between government and monetary authority does not introduction of a new national currency. Conversely, the only depend on personality and outside support but will deletion of apparently inoperative constraints on fiduciary also be influenced by the institutional framework in which issue or lending to government might create expectations their interaction is established. Otherwise, much less that the authorities did in fact intend to violate their con- attention would be devoted to the design of central bank- ditions. Even if the rules in force served no immediate ing institutions than has been throughout the world— purpose, their removal could still have an undesirable from Bhutan, now setting up its very first monetary destabilizing effect on the system. authority, to the United States, where relations between The organizational structure established by legislation the Federal Reserve Board and the Executive have been probably plays a more positive part in determining a cen- the subject of continuing debate. While limits may exist to tral banking institution's characteristic behavior. Operat- what can be achieved by statutory means, the existence of ing procedures, channels of communication, and lines of such limits merely underlines the need for care and atten- command all exert some influence on where and how deci- tion to the legislative and organizational form of central sions are made in practice. Seemingly mundane matters, banking institutions. such as rights of access for consultation and powers of

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©International Monetary Fund. Not for Redistribution References

Bhatt, V.V., "Some Aspects of Financial Policies and Central Hayek, F.A., Choice in Currency: A Way to Stop Inflation Banking in Developing Countries," World Development, Institute of Economic Affairs (, 1976). Vol. 2 (October-December 1974), pp. 59-67. Horsefield, J. Keith, "Why a Central Bank?," Finance & Devel Blejer, Mario I. and Mohsin S. Khan, 'The Foreign Exchange opment, Vol. 2 (September 1965), pp. 159-66. Market in a Highly-Open Developing Economy: The Case Khatkhate, Deena R. and Brock K. Short, "Monetary and Cen- of Singapore," Journal ofDevelopment Economics, Vol. 12 tral Banking Problems of Mini States," World Develop- (February-April 1983), pp. 237-49. ment, Vol. 8 (1980), pp. 1,017-25. Brimmer, Andrew F., "Central Banking and Economic Develop- Kock, M.H. de, Central Banking (London: Crosby Lockwood ment: The Record of Innovation," Journalof Money, Credit Staples, 1974). and Banking, Vol. 3 (November 1971), pp. 780-92. Kydland, Finn E. and Edward C. Prescott, "Rules Rather than Coats, Warren L., Jr., "The Efficacy of Monetary Rules for Discretion: The Inconsistency of Optimal Plans," Journal LDCs" in Money and Monetary Policy in Less Developed of Political Economy, Vol. 85 (June 1977), pp. 473-91. Countries, ed. by Warren L. Coats, Jr. and Deena R. Maynard, Geoffrey, "The Economic Irrelevance of Monetary Khatkhate (Oxford: Pergamon Press, 1980), pp. 165-81. Independence: The Case of Liberia," Journal of Develop Duvaux, Phillipe G., "Main Features of Bank Supervision in a ment Studies, Vol. 6 (January 1970), pp. 111-32. Selected Number of Countries," International Monetary Morgan, David R., "Fiscal Policy in Oil Exporting Countries, Fund, Central Banking Seminar, Vol. 2 (Washington, 1972-1978," International Monetary Fund, Staff Papers, 1982), pp. 21-35. Vol. 26 (March 1979), pp. 55-86. Fair, Don, "The Independence of Central Banks," The Banker, Nsouli, Saleh M., "Monetary Integration in Developing Coun- Vol. 129 (October 1979), pp. 31-41. tries," Finance & Development, Vol. 18 (December 1981 Galbis, Vicente, "Relations Between the Central Bank and the pp. 41-44. Public Sector: and the Bahamas," International Mone- Olakanpo, J.O., "Monetary Management in Dependent Econ- tary Fund, Central Banking Seminar, Vol. 1 (Washington, omies," Economica, Vol. 28 (November 1961), pp. 395- 1982), pp. 129-39. 408. Giddy, Ian H., "The Principles and Practice of Bank Supervi- Oliver, Brian, "Central Bank Functions in Less Developed sion: Main Features, Evolution and Possible Alternatives," Countries: The Case of Swaziland," Lloyds Bank Revie International Monetary Fund, Central Banking Seminar, (November 1979). Vol. 2 (Washington, 1982), pp. 2-20. Sayers, R.S., "Central Banking in Underdeveloped Countries" Grant-Suttie, Ian and Hassanali Mehran, "Relations Between a in Central Banking After Bagehot (Oxford: Clarendon Central Bank and the Central Government," International Press, 1957), pp. 108-33. Monetary Fund, Central Banking Seminar, Vol. 1 (Wash- ington, 1982), pp. 27-42.

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©International Monetary Fund. Not for Redistribution Occasional Papers of the International Monetary Fund (Continued from inside front cover)

22. Interest Rate Policies in Developing Countries, by the Research Department of the International Monetary Fund. 1983. 23. International Capital Markets: Developments and Prospects, 1983, by Richard Williams, Peter Keller, John Lipsky, and Donald Mathieson. 1983. 24. Government Employment and Pay: Some International Comparisons, by Peter S. Heller and Alan A. Tait. 1983. Revised 1984. 25. Recent Multilateral Debt Restructurings with Official and Bank Creditors, by a Staff Team Headed by E. Brau and R.C. Williams, with P.M. Keller and M. Nowak. 1983. 26. The Fund, Commercial Banks, and Member Countries, by Paul Mentre. 1984. 27. World Economic Outlook: A Survey by the Staff of the International Monetary Fund. 1984.

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