Perspectives on the Role of a Central Bank

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©International Monetary Fund. Not for Redistribution ggggs

Paul A. Volcker Miguel Mancera Jean Godeaux

Proceedings of a conference held in Beijing, China, January 5-7, 1990

People's Bank of China International Monetary Fund United Nations Development Programme

Washington, D.C., 1991

Cover design by IMF Graphics Section

Cataloging-in-Publication Data

Perspectives on the role of central bank / Paul A. Volcker, Miguel Mancera, Jean Godeaux [speakers]. — Washington, D.C.: International Monetary Fund, 1991. p. ; cm. Proceedings of a conference held in Beijing, China, Janu- ary 5-7, 1990. Jointly sponsored by: People's Bank of China, Interna- tional Monetary Fund, and United Nations Development Programme. ISBN 1-55775-206-0 1. Banks and banking, Central — Congresses. 2. Monetary policy — Congresses. I. Volcker, Paul A. II. Mancera, Miguel. III. Godeaux, Jean.

HG1811.P47 1991

Price: US$12.50

Address orders to: International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, D.C. 20431, U.S.A. Telephone: (202) 623-7430 Telefax: (202) 623-7491 Cable: Interfund

©International Monetary Fund. Not for Redistribution Foreword

a1 he International Conference on Central Banking, jointly sponsored by the People's Bank of China (PBC), the International Monetary Fund (IMF), and the United Nations Development Programme (UNDP), was held at the Diaoyutai State Guesthouse in Beijing, China on January 15-17, 1990. The conference was chaired by Richard D. Erb, Deputy Managing Director of the IMF, and co-chaired by Li Guixian, State Councillor and Governor of the PBC, and Roy D. Morey, Resident Representative, UNDP. Opening remarks were given by Mr. Erb, Gover- nor Li, and Mr. Morey, and at each session presentations were made by a representative of the People's Bank of China as well as by Paul A. Volcker, former Chairman of the Board of Governors of the U.S. Federal Reserve System, Miguel Mancera, Governor of the Bank of Mexico, and Jean Godeaux, former Governor of the National Bank of Belgium and former President of the Bank for International Settlements. At the end of each session, Mr. Erb gave a summing up of the discussion. The conference was attended by over forty senior Chinese government officials and academics from the State Planning Commission, the State Commission for Restructuring the Economic System, the State Council Development Research Center, the Ministry of Foreign Affairs, the Ministry of Finance, the Ministry of Foreign Economic Relations and Trade, the Ministry of Materials, the Ministry of Commerce, the Ministry of Agriculture, the State Audit Administration, the State Statis- tics Bureau, the State Price Bureau, the State Administration of Taxa- tion, the specialized banks, the provinces of Guangdong, Jiangsu, Lia- oning, Qinghai, and the municipalities of Beijing, Shanghai, Shenzhen, Wuhan, and Chongqing. The purpose of the conference was to invite leading central bankers from different parts of the world to discuss their experiences with various aspects of central banking with senior Chinese government officials. The main issues were the role of monetary policy in macroeconomic management, its formulation and implementation, the role of central banks in the supervision and regulation of the financial system, and the internal structure and responsibilities of central banks.

©International Monetary Fund. Not for Redistribution vi FOREWORD

The book is compiled from speeches made at the conference and is jointly published, both in Chinese and English, by the PBC, the IMF, and the UNDP.

©International Monetary Fund. Not for Redistribution Preface

s1 his book presents the proceedings of a conference on the role of central banks held in Beijing, China, in January 1990. The purpose of the conference was to bring to China the experience of central banks in other countries. Three distinguished and experienced central bankers were invited: Paul A. Volcker, former Chairman of the Board of Gover- nors of the U.S. Federal Reserve System, Miguel Mancera, Governor of the Bank of Mexico, and Jean Godeaux, former Governor of the Bank for International Settlements. To set a context for the discussion from the perspective of China's experience, senior officials from the People's Bank of China also gave presentations. Given the breadth, depth, and diversity of experience reflected in each of their presentations and the relevance of that experience to other countries, it was decided to pub- lish the proceedings. China is not alone in its interest in central banking. In recent years, because of concerns about persistent inflation, as well as concerns about the safety and soundness of banking systems, many industrial and developing countries have been examining the role of their central banks. These examinations reflect a renewed awareness of the significant impact central bank policies and decisions can have on economic performance. In addition, many countries implementing economic reforms have taken steps to strengthen their central banks. The International Monetary Fund (IMF), conceived more than four decades earlier, stands as the institution of the world most closely associated with the central banks of its growing membership. The evolution and role of the IMF has enabled it to identify with and support the process of developing effective central banks in countries undergoing economic reform. This conference is but one example of the many ways the IMF plays this role, but, more generally, the entire activities of the IMF are directed toward promoting economic growth with stability in a framework of international cooperation. Central banks are key institutions in this process.

RICHARD D. ERB Deputy Managing Director International Monetary Fund

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©International Monetary Fund. Not for Redistribution Acknowledgmet

ajl1 success of the International Conference on Central Banking, held in Beijing, China in January 1990, is due to the mutual efforts of Gyorgy Szapary and Linda M. Koenig, of the International Monetary Fund, Governor Li Guixian, of the People's Bank of China, and Roy D. Morey, of the United Nations Development Programme, all of whom carefully nurtured the idea of such a conference into reality. My sincere thanks go also to Dai Qianding, Executive Director, and Zhang Zhixiang, Alternate Executive Director, for their untiring assistance and advice, to the many translators at the conference who ably provided simultaneous translation, and to Juanita Roushdy, of the Ex- ternal Relations Department of the IMF, who edited the proceedings.

RICHARD D. ERB Deputy Managing Director International Monetary Fund

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©International Monetary Fund. Not for Redistribution Contents

Page Foreword v Preface vii Acknowledgment ix Overview 1 Opening Remarks 4 Richard D. Erb 4 Li Guixian 5 Roy D. Morey 7

Session I Role of Monetary Policy 9 Introduction Richard D. Erb 9 Speakers — Li Guixian 9 hs Paul A. Volcker 12 Miguel Mancera 18 Jean Godeaux 23 Summary of Discussion Richard D. Erb 26

Session II Implementation of Monetary Policy 28 Speakers — Zhou Zhengying 28 dds Paul A. Volcker 32 Miguel Mancera 36 Jean Godeaux 41 Summary of Discussion Richard D. Erb 42

©International Monetary Fund. Not for Redistribution xii CONTENTShhhh

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Session III Role of Regulation and Supervision of the Central Bank 45 Speakers — Tong Zengyin 45 Paul A. Volcker 47 Miguel Mancera 52 Jean Godeaux 56 Summary of Discussion Richard D. Erb 59

Session IV Structure of the Central Bank 61 Speakers — Chen Yuan 61 sff Paul A. Volcker 64 Miguel Mancera 70 Jean Godeaux 75 Summary of Discussion Richard D. Erb 79

Conference Summary 81 Speakers — Richard D. Erb 81 Paul A. Volcker 83 Miguel Mancera 84 Jean Godeaux 85

List of Participants 86

©International Monetary Fund. Not for Redistribution Overviejj

A conference, jointly sponsored by the People's Bank of China, the International Monetary Fund, and the United Nations Develop- ment Programme was held in Beijing on January 15-17, 1990. The following are some of the most important points made at the conference by the guest central bankers. During their presentations, and the discussions, the guest central bankers drew on their own experiences as well as their knowledge of developments in a broad range of countries.

KEY OBJECTIVES OF ECONOMIC POLICY AND ROLE OF THE CENTRAL BANK It was agreed that every government faces multiple objectives. Among these are growth, development, full employment, external equilibrium, price stability, and equitable income distribution. The key question for the meeting was in what way the central bank can best contribute to the achievement of these objectives. All agreed that the central bank should assign priority to the achievement of price stability, as this is a necessary condition for maintaining high saving and investment, exchange rate stability, and good longer-range planning—all of which are crucial to economic growth and development, whatever the particular mix of central direction and market regulation.

IMPORTANCE OF OTHER POLICY ISSUES TO THE EFFECTIVENESS OF MONETARY POLICY Monetary policy implementation and its success in achieving price stability in every country depend importantly upon the structure of the economy, and on other economic policies. Some of the key structural factors mentioned included the degree of price and wage flexibility and the rate of saving. For example, price and wage flexibility were seen as essential if reliance is to be placed on greater market regulation. Among other government policies, fiscal policy is especially important. As indicated by the experience of many developing and developed countries, excessive fiscal deficits can make the implementation of monetary policy much more difficult by putting pressure on the central bank to finance the deficit directly, where that is permitted, or indirectly, by

©International Monetary Fund. Not for Redistribution 2 OVERVIEW inducing other financial institutions to do so. In addition, the financing of fiscal deficits can mean fewer resources for other productive investments in industry, agriculture, and other sectors, and lead to excessive foreign borrowing. The central bank and finance ministry should be natural allies on overall economic issues, particularly in resisting the expenditure pressures from other government bodies. A good working relation does not preclude that there will at times be differences on particular issues as each pursues its primary responsibilities.

CONTINUITY IN MONETARY POLICY Drawing on the experience of many countries, particularly the experience during the 1970s, it was concluded that it is extremely important that governments pursue continuity in monetary and other macroeconomic policies, striving to avoid extremes of "boom or bust." Stop-and-go cycles of expansion and contraction weaken the confidence in government economic policies and undermine the climate for saving and productive investment. All the speakers agreed that a stable environment was the most conducive to economic growth; theories to the effect that inflation and growth go hand in hand have not been borne out in practice. To achieve more continuity, it helps to make day- to-day decisions on monetary policy within a medium-term framework. These decisions on monetary policy will be assisted by close attention to growth in various measures of the money supply and to developments in the exchange market and external reserves.

DEVELOPMENT OF A STRONG FINANCIAL MARKET Broadening and deepening of financial markets and encouraging competition among financial institutions were seen as facilitating the implementation of monetary policy. In addition, the removal of obstacles to the full development of financial institutions and competition among financial intermediaries contribute to the allocation of credit to the most productive uses. There was a strong view that the central bank should avoid directly involving itself in credit allocation. To the extent that a governmental role in credit allocation was deemed desirable, this should be accomplished through the budget and other means, and not through the central bank. This is accomplished in some countries through budget support of development banks or other forms of budget-supported finance.

©International Monetary Fund. Not for Redistribution Overview 3

THE ROLE OF REGULATION AND SUPERVISION The experience of many countries indicates that regulation and supervision are essential for a stable and healthy financial system and that the needs become greater as the number and variety of financial institutions increase. Supervision entails not only the enforcement of rules and regulations, but also judgments concerning the soundness of a financial institution's assets, its capital adequacy, and its management. The central bank has an interest in these matters. Many countries favor giving the central bank primary responsibility for prudential regulation and supervision; also, if the central bank is not primarily responsible, it at least must have a strong presence in the supervisory process and have full authority for regulations dealing with monetary policy. Supervision and regulation are also used to encourage the development of, and efficiency in, financial intermediation, for example, by encouraging competition.

IMPORTANCE OF A STRONG AND AUTONOMOUS CENTRAL BANK Given its responsibilities, a central bank needs to be strong. Many factors that influence the strength of a central bank were discussed. Strong central banks have a high level of integrity and technical expertise and are professional and nonpartisan in the conduct of their responsibilities. Central bank autonomy is also desirable. This means not being subject to orders from other government departments, such as the finance ministry, and also having financial independence. Auton- omy does not mean that a central bank is not accountable. For example, a central bank needs to be sensitive to the broad social, political, and economic environment within which monetary policy is set, and an effective central bank makes every effort to explain its policy to other parts of the government and to the general public. A central bank and finance ministry ideally should work together in confidence, but without decisions being imposed on the central bank.

©International Monetary Fund. Not for Redistribution Opening Remarks

RICHARD D. ERB da 1 his International Conference on Central Banking is jointly sponsored by the International Monetary Fund, the People's Bank of China, and the United Nations Development Programme (UNDP). As many of you know, the International Monetary Fund (IMF) is a cooperative organization, with 152 member countries at present. The membership is diverse not only in size and stage of development but also with respect to economic, social, and political structures. All of the members of the IMF, however, share a common set of objectives. These objectives, which are stated in the Fund's Articles of Agreement, include growth of output and employment, price stability, and an open and growing international payments and trade system. The members of the IMF cooperate with each other in pursuit of these objectives in a variety of ways. I will not try to describe all of them, but one that I would like to emphasize is the way that members exchange information and analysis on each other's economy in the context of regular consultations with IMF staff and the IMF Executive Board. For example, members have been able to observe and discuss the developments in China over the past decade. I can report to you that members of the IMF have great respect and admiration for what China has been able to accomplish over the past decade in implementing economic reforms. China, through its economic reforms, including steps to open the economy to world trade and world capital, has been able to achieve, by comparison with many other nations, an outstanding rate of economic growth. I can also report to you that, from my perspective at the Interna- tional Monetary Fund, the recent years have been extremely dynamic for all of the world economy. Within the major industrial countries- including the United States, the European countries, Japan—economies have been undergoing significant changes and governments have been working to implement policies to achieve growth with price stability. Many of the debtor countries have been implementing economic reforms to deal with their external debt problems and to lay the basis for sustained economic growth.

©International Monetary Fund. Not for Redistribution Li Guixion 5

Many other economies in this region, for example, Viet Nam and the Lao People's Democratic Republic, are also implementing major economic reforms. We see economic changes taking place in countries like Hungary and Poland and in Africa, in countries like Tanzania, Mo- zambique, Nigeria, and Angola. This is a time of dramatic economic change, but the changes that are taking place throughout the world have not been without difficulty. Inflation in many countries has been difficult to bring under control. This has also been an issue of concern within China, and this brings me to the subject of today's conference. Members of the IMF recognize that to achieve economic growth on a sustained basis over time, it is necessary also to achieve stable financial and noninflationary conditions. This leads all of us to focus great attention on the role that central banks play in promoting the conditions for economic growth and stability. The subjects on the agenda for this conference are being discussed in many countries. I can report to you that many countries have been looking at ways to strengthen their economic policy-making and, particularly, to strengthen the role of their central banks, in order to improve prospects for growth and price stability. Countries like New Zealand, Chile, Hungary, Yugoslavia, and Tur- key have all been implementing reforms in their banking systems and within their central banks. In those countries where central banks are not going through major structural changes, a great deal of attention is being paid to the question of how to achieve greater financial and price stability. This conference brings to you the perspectives of central bankers from different economies. Mr. Volcker, Mr. Mancera, and Mr. Godeaux come from very different economies, economies that have also been pursuing the objectives of achieving stable economic growth and reasonable price stability. These are men who have demonstrated an ability to bring inflation down. You will be hearing from men who have fought the war and have succeeded in achieving their objectives. I am sure that during the course of the discussion they will have, at times, different perspectives on the issues that are before us today. I am sure that each of you will have questions or comments or suggestions and that through them we can establish, during the course of the next two days, a dialogue that will enable each of us to share views on how to achieve the objectives of growth and stability.

Li GUIXIAN

sjaAt the outset please allow me, on behalf of the People'sfhgh China and the Chinese participants, to extend a warm welcome to friends who have come a long way to be with us, and to express our

©International Monetary Fund. Not for Redistribution 6 OPENING REMARKS heartfelt thanks to the International Monetary Fund and the United Nations Development Program who have spared no effort in actively promoting and working toward the opening of the conference. The conference is being held at a time when we have just bade farewell to 1989 and are ready to embrace the first spring of the 1990s. Over the past twelve months—owing to the timely implementation of stabilization policies by the Chinese authorities—the overheating of the economy and the inflation plaguing the economy in recent years have been held under initial control, and the imbalance between aggregate supply and aggregate demand has eased somewhat. Progress has also been made in other parts of the economy. The initial results gained through the policy of stabilization and the deepening of economic reform will further enhance our confidence in the overall achievement of stable economic growth. We have come to the realization that, in order to maintain a sustained and coordinated growth, efforts need to be made to coordinate every aspect of economic policy. And, among other factors, the monetary policy of the central bank must be accorded a relevant weight. With the deepening of the economic reform in China, a monetary policy with new meaning and vitality has evolved. In this context, only when the functions of the central bank are strengthened will the central bank be able to gradually play an effective role in regulating the macroeconomy. The 1990s will be a key decade for China to fulfill its economic development strategy; it will also be a decade full of hope and challenge. The year 1990, itself, will be critical for us to attain our overall goal of stabilization. During the course of the new year, not only will we continue our efforts to combat inflation, but we will also endeavor to achieve a proper rate of growth for the economy, thereby paving the way for further reform and opening in a solid manner and enabling the economy to develop in a sustained and coordinated fashion. For these reasons, we wish to learn from and refer to experiences of various nations. We feel honored to have central bankers of world re- nown participating in this conference. They have amassed and are still amassing an extremely rich body of experience and skill in the course of tackling some difficult economic problems of a nationwide and world- wide nature. Needless to say, it seems that operating monetary policy is more of an art than a skill! The experience these central bankers possess covers a wide and varied representation. Therefore, we look forward at this conference to sharing the many-faceted aspects of their knowledge and experience. It is my belief that the conference will play a positive role in strengthening the functions of the People's Bank of China, the central bank of China, in macroeconomic regulation and, at the same time, will contribute toward enhancing friendly cooperation between

©International Monetary Fund. Not for Redistribution Roy D. Morey 7

the People's Bank of China and the International Monetary Fund, the United Nations Development Programme, as well as the central banks of various nations. Finally, I would like to express my best wishes for a successful conference.

ROY D. MOREY

ssOn behalf of the United Nations Development Programme (UNDP), I am very pleased to welcome you here to this International Conference on Central Banking. This meeting has generated considerable interest since 1988. At that time, China decided to host this conference, and the International Monetary Fund (IMF) and the UNDP joined in partnership to organize and cosponsor the event. The conference brings together an exceptional group: it includes both the distinguished individuals here today and other Chinese leaders who will be involved in consultations during the week. We are delighted that Messrs. Erb, Volcker, Mancera, and Godeaux have agreed to share their valuable time and experience with us. Additionally, I want to sincerely thank the People's Bank of China (PBC) and the Gov- ernment of China for not only hosting this meeting but also for the extraordinary efforts, support, and senior-level attention that has been given to assure the success of these consultations. To my mind, this international conference is an example of the Chinese Government's commitment to maintain its open-door policy and to pursue opportunities in accord with its policy to deepen economic and structural reforms. In recent months, the leadership of the Government of China has stated its overall economic objectives, namely, China seeks to achieve more stable, sustained, and harmonious economic growth and development. These are worthy goals. Moreover, these goals are common to many other countries that in recent years have faced similar swings of the economic cycle, trade and budget deficits, imbalances in the exchange rate, and high inflation. In fact, our distinguished foreign guests have made their international reputations by successfully dealing with these economic problems and the challenges of economic uncertainty and instability. It is not surprising that during our briefings by senior government officials, great interest was shown in receiving advice about preventing a return to inflation and the instruments to stimulate consumption and balanced production. No matter when this meeting would be con- vened, one preoccupation would be to examine the policy options and

©International Monetary Fund. Not for Redistribution 8 OPENING REMARKS instruments for the formulation and implementation of monetary policies and strategies. Our conference is intended to meet the desire to consult about such policy issues and also to lead to an examination of the monetary system, institutions, and capabilities that are necessary in order to achieve China's economic goals. Even if potentially effective short-term policy prescriptions are identified and implemented, experience has shown that systemic problems will jeopardize their success. As our agenda directs us toward the examination of systemic problems and solutions, I wish to make three points. First, major decisions with respect to monetary policy and banking necessitate transition through three stages: (1) the identification and elaboration of options; (2) the formulation of policies and their action plans; and (3) implementation and feedback. Second, in each of these stages, effective management and effective systems are prerequisites for successful action. These include (1) the availability of adequate quantitative data and information; (2) competent analysts and managers capable of utilizing the data and information; (3) systems to channel the data that will facilitate a two-way flow of information so that it can be shared among policymakers, as well as managers who are responsible for implementing monetary policy; and (4) effective monitoring and feedback systems for constant policy adjustment. In short, the type, volume, flow, and utilization of information are critical. This is especially important so that China (or any other country) can avoid sudden or extreme shifts in policy that result in drastic swings in production, prices, and consumption. Third, for many functions in the policy process, information must be shared. Systematic and continuous consultation must occur, to assure both the vertical harmony and cooperation (such as between central and branch bank offices) and horizontal policy coordination among the various central institutions (such as China's major banks and the Ministry of Finance). Top-quality human resources, institutional capacity, and effective systems are therefore necessary compo- nents of successful monetary and banking policy-making. In recognition of this fact, the UNDP has been providing technical assistance to the People's Bank of China and a large number of other ministries and institutions represented here at the conference. We have every inten- tion of continuing to provide additional assistance in the future. Your deliberations this week will be useful in identifying such needs. This conference represents a new collaborative relationship between the UNDP and the IMF in China. In looking ahead at China's future needs, we would be pleased to see this partnership strengthened.

©International Monetary Fund. Not for Redistribution Session I Role of Monetary Policy

RICHARD D. ERB

jLet us turn now to our first session. Each speaker will address a number of issues, including, for example, the question of whether there is a primary economic task for monetary policy: price stability, exchange rate stability, and growth. What are the relationships between those objectives? Are there differences between the short run and the long run in the pursuit of those objectives? How does the overall structure of an economy influence the role of monetary policy? These and other issues will be addressed in the context of this session, and this will then lay the basis for Session II, which will focus more specifically on issues concerning the implementation of monetary policy.

Li GUIXIAN

sIt is a great pleasure for me to have this opportunity to discuss the issues of monetary policy with Mr. Volcker and other distinguished guests. I am going to speak on the role of monetary policy and its relation to credit allocation and fiscal policy. Monetary policy is one of the most important of the macroeconomic instruments. The objectives of monetary policy in a country can be quite different in various periods of time owing to differences of economic development, financial structure, and economic policies. Generally, price stability, full employment, economic growth, and balance of international payments are regarded as the basic objectives of monetary policy. In the present-day world, because consistency and conflict exist between various objectives of monetary policy, central banks usually lay different emphasis on different objectives. They make frequent adjustments to the policy measures in view of the status quo of their country's political, economic, and social development. In this way, they maintain the equilibrium of aggregate demand and aggregate supply and promote balance and sustained economic growth.

©International Monetary Fund. Not for Redistribution 10 ROLE OF MONETARY POLICY

China is developing its planned commodity economy. The central bank has persistently deemed monetary stability and economic development to be the basic objectives of monetary policy. We believe that the key to handling all four objectives is to prudentially balance the relationship between stabilization and development. In fact, stabilization and development are mutually conditional and complementary. Monetary stability is the prerequisite of economic development, and, in turn, economic development is the solid foundation for monetary stability. Monetary stability is regarded as the fundamental, dynamic, and long-term equilibrium of money supply and money demand, not ex- cluding the temporary disequilibrium over time of price adjustment and price structure reform. Only through active stabilization can economic development be best promoted. On the other hand, economic development should proceed at a steady and sustained rate so that economic development cannot only be prevented from disturbing stability but can also help maintain stabilization. To integrate the objectives of monetary stability and economic development, attention should especially be paid to the following aspects. Emphasis should be placed on a specific objective in a particular period in light of the existing situation. For instance, we have recently been exerting additional effort to tighten monetary policy and promote price stabilization and economic development. In China, the experience of recent years has suggested that monetary policy has developed into one of the main macroeconomic instruments in the Government's effort to transform direct control over the economy to indirect control. It has played an active role in controlling the scale of fixed capital investment, containing the excessive growth of consumption funds, channel- ing savings to investment, adjusting the economic structure, augment- ing effective supply, maintaining price stability, and promoting balanced economic growth. Apart from the choice of the objectives, the formulation and implementation of monetary policy also involve the issue of intermediate targets, instruments, transmission mechanisms, and the analysis of effects. I will address the relation of monetary policy and credit allocation. Credit allocation is a selective monetary policy instrument distinct from quantitative control methods, such as required reserves and rediscount and open market operations. Since this instrument was first introduced in the eighteenth century by the Bank of England, central banks around the world have made use of it in one way or another at different times. Even today, although general quantitative methods have been extensively applied in the developed countries, some of them have not altogether discarded the instrument of credit allocation.

©International Monetary Fund. Not for Redistribution Li Guixian 11

In the developing countries, including China, it remains the dominant one in the apparatus of central banks. As far as I perceive, a country's fund allocation system is determined by its economic and financial system, as well as by the maturity of its financial markets. In our case, banks are not only commercial entities conducting banking business but are also units empowered by the state to undertake policy lending—specialized banks especially, as the state banks are not supposed to operate for profit only or, rather, they are required to take on certain functions of macroeconomic regulation and control. Furthermore, as a developing country, China is constantly confronted with an ever-growing demand for funds and the urgent need to adjust its economic structure. Abandonment of the credit allocation system would leave unsecured the sufficient flow of funds to priority sectors and enterprises of economic development and structural adjustment. On the other hand, underdevelopment of financial markets severely limits the central bank's ability to regulate the economy through open market operations and rediscounting. Nevertheless, we are aware of the defects of a credit allocation system. We maintain that the key to the effective implementation of monetary policy in the present Chinese context is the coordination of different policy instruments. For this purpose, efforts should be made to perfect the policy instruments in light of the reality of China, while maintaining the system of credit allocation. For instance, steps may be taken to improve the system of loan quotas, special deposits, and required reserves and to adjust interest rates, set lending structure guidelines, formulate a social credit plan encompassing all credit demands, promote the growth of interbank lending market, etc. Much work is also needed to better coordinate the conduct of various instruments to make them support and supplement each other so that the role of each individual instrument will be brought into the most effective play. Both monetary and fiscal policies are indispensable tools for aggregate demand management. Fiscal policy is effected through the distribution of national income and the change of budgetary expenditures; monetary policy is effected through the adjustment of the money supply. In my view, the combination of these two policies, whether to tighten or to relax both of them or to tighten one and relax the other is determined by the specific conditions of the economic system and the economic operation mechanism of the country in question. The existing economic operation mechanism in China is quite different from the market mechanism in Western countries. The Chinese economy is an integration of a planned economy and market regulation. Monetary and fiscal policies are conducted not only for aggregate

©International Monetary Fund. Not for Redistribution 12 ROLE OF MONETARY POLICY

management but also for the needs of structural adjustment. For instance, in view of the current excess of aggregate demand over aggregate supply, the overall direction of monetary and fiscal policy is set to both control aggregates and adjust the economic structure. Therefore, pursuant to the structural adjustment policy, sufficient funds will be granted to priority sectors and enterprises, and fiscal expenditures beneficial to structural adjustment will be expanded despite the fact that both monetary and fiscal policies have been tightened. With respect to the resource allocation through monetary and fiscal policy, our approach is to maintain the individual balance of fiscal and credit resources, respectively, as well as their overall balance. For those construction projects that have total credit resources, funds will be provided as much as possible from banks. As for those projects that can be financed by neither credit nor fiscal resources, funds will be raised by issuing bonds, through the fiscal sector, to households, enterprises, and financial institutions so as to discourage the direct purchase of such bonds by the central bank. Finally, it should be stressed that the effective coordination and supplementation of monetary and fiscal policy require the concerted action of other economic policies, such as investment policy and the support of various means, such as administrative measures.

PAUL A. VOLCKER

1 appreciate personally this opportunity to join this forum and this conference. As Mr. Erb emphasized at the start, China has had remarkable success with its program and process of reform and opening. It is fair to say that you also have a remarkable set of problems. One senses that you are at a particularly critical time in your economic development and, inevitably, have many questions unique to the Chi- nese economic and political situation. In reading about China before coming here and listening to Governor Li and talking with some of you, I was struck by the similarity of some of our problems, a similarity of problems with countries in quite different states of development. Let me say that, from my particular perspective, I understand it is much easier to give advice than to take responsibility. I am these days in the happy position of giving rather than taking advice, but I have greater respect for those of you who must not simply talk about problems but must act. I listened to Governor Li's statement with great interest. He emphasized a unique combination of planning and regulation in China. Many of his comments sounded quite familiar. He described the multiple goals of monetary policy for full employment, for growth, for balance

©International Monetary Fund. Not for Redistribution Paul A. Volcker 1 3 of payments' equilibrium, and for price stability. I was struck by the fact that those very same phrases appear in all the directives of the Federal Reserve Board in the United States. Sometimes we engaged in great debates as to which of those wonderful four objectives ought to be listed first, second, and third, in particular situations. But, first of all, I want to draw a lesson from that. Obviously, monetary policy authorities like to do good in all situations. They would like to see the economy operate with growth, full employment, balance of payments equilibrium, and price stability. We all want to be wise and flexible and adjust our policy instruments to achieve all of those objectives. But I am not sure that that is saying much more than as intelligent, humane people we want to do good. The question is whether we can always do good in all directions at the same time. Monetary policy is an important aspect of economic policy, but it is only one instrument of economic policy. The unique characteristic of monetary policy is that it deals with money and, in dealing with money, it inevitably deals with markets. Money itself produces nothing, but without money there cannot be efficient markets, and, conversely, without reasonably efficient and effective markets, there is no real purpose in monetary policy. What is important, if we are going to have well-functioning markets, is that there be some sense of monetary stability. Without a sense of monetary stability, I do not think we can have a very effectively operating economy—one in which other participants can produce, will be willing to save, will be willing to invest in the future, and will be able to trade freely with other countries. I am using monetary stability in a very broad sense. I am thinking of reasonable stability in exchange rates. I am thinking of continuity in financial markets so that one can plan today what might reasonably happen tomorrow. I am thinking of encouraging performance on financial contracts and providing for the repayment of debts on a planned basis, of providing for a basis for lending on reasonable terms, and, when I think of monetary stability, I am thinking, above all, of price stability. A point that I would like to emphasize is that monetary stability is the first priority of monetary policy, and, when there is a choice of objectives, that is the one that should be emphasized. What that means more broadly is that central banking and monetary policy require a constant sense of placing limits on money and credit creation. Those limits may change from time to time depending upon economic circumstances, but we must always think in terms of appropriate limits because, when money and credit creation is excessive, we will lose the

©International Monetary Fund. Not for Redistribution 14 ROLE OF MONETARY POLICY monetary stability necessary for economic activity to perform op- timally. That does not put central banks in a very popular position. One of my colleagues as chairman of the Federal Reserve Board used to put the point very simply: he said the function of monetary policy and the function of a central bank was to take away the punch bowl just when the party got good. Another American commentator, in a rather critical way, described a central banker as a person who is always fearful that someone else may be happy. The fact is that the function of the central bank is to set limits, to set a framework—which other people may not like—that provides an environment in which growth and stability may be achieved in the interest of the economy as a whole. I want to quote two different authorities for that view. German monetary policy and central banking is often widely admired. One reflection of that is in the basic law of the German central bank, the Deutsche Bundesbank. A broad instruction given to that body is very uncomplicated; it says defend the stability of the currency; it does not say anything about economic growth; it does not say anything about the balance of payments; it does not say anything about full employment. I do not think it a pure coincidence that the Federal Republic of Germany has had a strong balance of payments or that it has had good growth and a strong economy during the postwar period. My other authority is quite different; I am thinking of Mr. Lenin, who reminded capitalist countries that the greatest danger to their stability would be inflation debauching the currency. The point I am trying to make is not a matter of economic ideology. Let me just briefly turn to some characteristics of recent U.S. experience. By the standards of elsewhere, we, for many years, have had reasonable success in stability. At least, we have never had extreme inflation. But we did have serious inflation in the 1970s and early 1980s, in fact the most serious inflation in our entire short history—only two hundred years. We had that inflation partly because, with the best intentions, decisions were taken to create more money in the interest of economic growth and low unemployment. The lesson was that we ended up with more unemployment and less growth; once the inflationary process gained momentum, it was very difficult to restore stability without more economic difficulty and without still more unemployment and monetary instability than we would like. If there is any reality to what I am saying, the second point that I would make is that it is very difficult to explain to the general public what is happening. In a simple way, more money in the pocket always seems good. If you have more money, you can buy more, and the connection between more money and more inflation, and more instability is not always clear, but if in fact that is the truth, I think it is

©International Monetary Fund. Not for Redistribution Paul A. Volcker 15 also the truth that a central banking organization, whatever its precise form, will need strong public support and strong public understanding. It will need to be able to explain itself to the public very clearly. It will need the understanding of other parts of the government, however unhappy some of the public or other government agencies may be when they too have to live within the sense of restraint that is implied. I think that we in the United States are better off in this respect now than we have been for some years, precisely because we went through this difficult experience in the 1970s and early 1980s. The general public understands better than it did the importance of monetary restraint and of not permitting inflation to get a good head start. There may be some similarities to your recent experience. A third point is that how monetary policy works in the United States or anywhere will depend upon other characteristics of the structure of the economy and other elements of economic policy. Let me take just two aspects of that from recent American experience. As inflation in the United States reached high levels, the budget deficit got larger rather than smaller—the American economy is characterized by low saving. In fact I might say, as an aside, that I find some of the figures that I see for saving in China, as a percentage of income and as a percentage of GNP, unbelievable from an American perspective; as a fraction of income, you save several times what we save. In any event, our saving has been rather low for decades, but during the 1980s, the already low level of saving dropped further to the point that it was totally inadequate to cover both the budget deficit and even minimal investment needs at home. This encouraged a lot of capital investment from abroad; so we had the odd situation of the largest and richest economy in the world, with relatively low investment and high interest rates, being dependent upon the capital of other countries. I do not argue that that was a desirable situation, quite the contrary, but the operating question for the central bank was what to do about it. The central bank does not control saving, at least not directly; it does not control the fiscal deficit; what it can do is create money. But the judgment was made that the creation of money in this particular situation would only have added a third large problem, namely, inflation, to the already existing problems of budget deficits and trade deficits. I happen to think that that was a correct judgment, but I point out that it did not cure either the trade deficit or the budget deficit or the shortage of capital at home; we had to look to different policies, and some of those I think are now working to cure those particular problems. Another aspect is the flexibility of prices or, looked at another way, the rigidity of wages and prices in an economy. It is clear that if we are going to have price stability overall in a reasonably dynamic economy,

©International Monetary Fund. Not for Redistribution 16 ROLE OF MONETARY POLICYhhhhhhh some individual prices will have to go up to attract more resources into particular sectors, and as some prices go up other prices will have to go down. I think that it is logically correct that if no prices go down and some prices go up you cannot have overall stability. A lot of countries, including the United States, have not had much downward flexibility in prices. And when one thinks about the relative success of anti- inflationary policies in the United States in the 1980s, one would not look just to monetary policy. There was an important, substantive, and symbolic event in 1981 in the United States: a strong trade union—the air controllers—that considered its members absolutely essential to keep aircraft flying in the United States went on strike for a variety of reasons; air controllers are public employees. I am sure they expected that the strike would be settled quickly because they were engaged in a vital service and that they would largely achieve their objective. Instead, the Government decided to draw the line; it felt the strike was illegal and even apart from any argument over the merits of their complaints, it decided it would not settle the strike, and instead started over again by hiring and training new air controllers. I do not argue the specifics of that case, whether the Government was right or wrong in terms of the benefits the controllers were looking for, what I do argue is that the attitude of the Government toward that strike changed in a very important way the attitude of labor unions all over the United States, and really for the first time in the postwar period led to a different kind of wage determination, including the willingness of some labor unions to accept lower wages in order to keep jobs in industries that were doing poorly. That restraint in wages continues until today and has made it possible, I believe, to employ some twenty million more people in the United States today than ten years ago. That may not sound like much to a Chinese, but it is a lot for us—a 20 percent increase in employment during a decade in the context of economic growth, diminishing unemployment, and greater price stability. My final point, just briefly, is a comment on the question of credit allocation and direct credit controls that the Governor mentioned, and, as he indicated, I think practically all central banks have had some experience in that area. It is also true, in the United States and in highly developed economies generally, that the idea of credit allocation and direct credit controls is rather out of fashion for several reasons. One is that from the viewpoint of the Federal Reserve, in particular, the temptation to rely upon direct credit controls will be seen very frequently by the public at large and by other government agencies as an easy substitute for restraining the overall money supply. But I think experience is quite clear that if we run a kind of two-horse policy, direct restraint

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on credit but expansion of the overall money supply, we will eventually have both inflation and a distorted economy. That may appear somewhat different in a planned economy where credit restraint—direct credit restraints in some cases—may play a role, but I would bring to your attention not just experience in the United States but experience in the U.S.S.R. once again, where they certainly have a lot of direct credit restraints, but at the same time, they have had an enormous expansion in the money supply and the result, as nearly as I can judge at present, is rather a mess. I do not think that you can use direct credit controls as a substitute for overall restraint. Let me look at the other side of the coin. Is there some role for credit allocation, for subsidies, for the central bank promoting a big supply of credit in critical areas of the economy? Again, I can only report to you the attitude and experience of those of us in the United States. The Federal Reserve has often been asked to provide credit on particularly favorable terms to sectors of the economy that either have special problems or are deemed to have special potential. Invariably, those requests are resisted, usually successfully. They are resisted for a simple reason: there has been a fear on the part of the central bank through the years that if you begin using the process of money creation through the central bank to support one area of the economy or another, it will be practically and psychologically impossible to, at the same time, restrain the creation of money generally. In sheer political or bureaucratic terms, it is difficult to drive a car in two directions at the same time, and if you create the impression that the central bank can use its funds for supporting particular areas of the economy, it is difficult to know how and when to stop, because demands will only multi- ply. Every sector of the economy feels that it is particularly oppressed or that it has particular potential. The whole point of limiting the money supply is that all of those demands cannot be met. So it has been argued in the United States that you better not start because you do not know where to stop. That does not mean that we in the United States, as in other countries, do not provide special privileges for particular areas of the economy, but those benefits are provided through the budget or sometimes through special laws and regulations. They are not provided through the process of money creation and through the central bank. I know China is in a somewhat different situation in that respect particularly with its needs for structural adjustment and for developing markets, but I tell you our experience for what it is worth. Finally, I would report on another practical approach. Our experience increasingly is that direct controls do not work well in a developed market economy, for several reasons. We do not know enough in Wash- ington or in the Federal Reserve to judge precisely what kind of direct

©International Monetary Fund. Not for Redistribution 18 ROLE OF MONETARY POLICYjjjklh controls and what rules and regulations are suited to the great variety of markets and individual firms that exist in the country. I know from personal experience that it is extremely easy to misjudge the effects on the economy of direct controls, because the effect depends in part not upon what you intended but on what the population fears and thinks you might intend. One of the dangers is that a particular measure of restraint might be interpreted as a forerunner of further measures of restraint, and people will react as much to what they fear in the future as to what they see in the present. One last bureaucratic or political point. If monetary policy is to be conducted through a series of direct controls on direct allocation of credit, at least in our country, it is an invitation to constant controversy between particular departments and particular sectors of the economy as to who is being fairly treated and who is being unfairly treated. Questions are raised to which there simply are no answers. Some of those judgments have to be made by any government, but again in our experience we find it simpler to make those judgments through the budget, where there is at least some clear sense that if extra money is extended to one person or one sector, some other sector has to pay for it. In that sense, a budgetary priority puts some discipline on the process. If the same intervention is attempted by the central bank, through money creation, that essential sense of discipline on the total may be lost. Again I realize that these are comments and lessons drawn from the experience of a highly developed market economy, but they are not entirely irrelevant to some of the concerns that you must have in this very large and growing economy.

MIGUEL MANCERA

s It seems to me that in discussing our subject it is useful to make a distinction between credit policy and monetary policy. These policies are closely linked to each other, but they are not synonymous. In my view, monetary policy is implemented through actions that have an effect on the balance sheet of the central bank. Credit policy is something wider: it includes monetary policy plus other actions of the authorities that may affect the volume or nature of the operations taking place in the financial system without changing the assets or the lia- bilities of the central bank. The ultimate objective of economic policy is to achieve the aims of society in an efficient way, that is, at the lowest possible cost. In modern times, growth has usually been the primary aim in most countries; so, for the sake of simplicity, we may assume this to be the case in our discussion. Of course, this does not mean that there are not at the same

©International Monetary Fund. Not for Redistribution Miguel Mancera 19 time other important objectives, such as the redistribution of income to make income more equitable. If the main objective of economic policy is growth, the objective of the component parts of that policy, including the monetary and credit policies, should also be the same. The question is how they can best make a contribution to economic growth. I have no doubt that in order to achieve growth, monetary policy should concentrate on achieving and maintaining price stability or, in other words, on achieving and maintaining a stable currency in terms of its domestic purchasing power. This stability is crucial because the evils of inflation are countless. By making relative prices and incomes highly volatile, and therefore unpredictable, inflation increases the difficulty of making the right investment decisions. Consequently, the yield of many projects turns out to be unsatisfactory. Moreover, assessing the probable costs and benefits of a project may become such a difficult task that the investment process is inhibited. Not only investment decisions but also savings decisions are much impaired by inflation. An important price that becomes volatile in times of inflation is the price of money, that is, the real interest rate. It has been found that when inflationary processes begin, real interest rates are often negative and that, for a time, this does not discourage people from saving. This is because, at that stage, people have not yet learned to distinguish between nominal and real interest rates. Over time, however, savers become aware of the this distinction and thus become reluctant to hold debt instruments unless they foresee that a positive and satisfactory yield is obtainable. A new difficulty is then encountered because inflation makes real yields hard to forecast owing to the volatility of the rate of price increases, even within short periods of time. A paradoxical situation arises: although observed real yields may have been extremely high, people may be reluctant to put their money into financial instruments. They may perceive that the likelihood of surges in the rate of inflation subjects future real yields to the risk of being dramatically diminished. Thus, a substantial difference appears between ex post rates, that is, the observed real interest rates in the past and ex ante rates, that is, the expected real interest rates. When ex post rates are high and ex ante rates are low, we have a most undesirable situation. Another evil of inflation is that it provides very fertile ground for economic distortions to develop. As the population reacts angrily to price increases, the authorities may be tempted to establish price controls. This temptation comes in spite of the fact that quite often the

©International Monetary Fund. Not for Redistribution 20 ROLE OF MONETARY POLICY authorities are well aware that shortages will ensue, which will exacer- bate the situation in the long run. Nevertheless, short-term pressures are very difficult to resist. It is likely that the first prices that will lag behind economic realities are those of goods and services provided by public sector enterprises. To prevent these firms from going into the red and eventually into bankruptcy, they have to be subsidized; thereby, public finances tend to deteriorate. This, in turn, increases the pressure on the central bank to provide excessive primary credit, which is usually the original source of inflation. To make matters worse, subsidies may not be restricted to public sector enterprises. Private firms may also be among the beneficiaries. In such circumstances, pressure for additional central bank financing will become even stronger. The widespread and abrupt fluctuations in relative prices that inflation brings about causes the real economic outcome of contracts to be substantially different from the expectation of the contracting parties. This produces windfall profits for one of the parties at the expense of the other. This process is very inequitable and many times angers not only those directly involved in the respective transactions but also large sectors of the population. In these conditions, the business climate deteriorates markedly. Moreover, much effort and resources are diverted from the production of goods and services to forecasting and hedging to avoid heavy losses. Another undesirable effect of inflation on contracts is that their terms tend to become shorter. Thus, economic activity is conducted in an atmosphere of extreme uncertainty, as contracts have to be replaced frequently. This clearly is detrimental to the economy. Finally, it can be said that the propensity for the rate of inflation to increase is remarkable and, even worse, the evil consequences of inflation tend to increase at a compound rate as price increases accelerate. At some point, the inflationary process utterly destroys the economic system. As we can see, there are plenty of powerful reasons to pursue stability. Stability should not be pursued for its own sake, nor for doc- trinaire considerations. Without it the ultimate goal of economic policy, sustained growth, is difficult to attain in an inflationary environment. Since inflation is such a harmful phenomenon, it must be fought with all our strength. The correct monetary policy is a necessary, although perhaps not sufficient, condition to achieve stability. In some instances, if monetary policy is correct, inflation can be avoided even when other policies do not contribute to stability. But if monetary policy is incorrect, in the sense that it is overly expansionist, inflation is bound to occur even when other elements of economic policy are con-

©International Monetary Fund. Not for Redistribution Miguel Mancera 21 sistent with stability. Thus, there is no substitute for good monetary policy to keep prices stable. In my view, exchange rate stability and balance of payments equilibrium should not be the final objectives of monetary policy, since the final objective is price stability. Yet the former can well be intermediate objectives, inasmuch as they may contribute to the achievement of the latter. In fact, when a country is closely linked to the international economy and there is a major foreign currency that is very stable, a policy of pegging the rate of exchange of the national currency to that foreign currency may be a very effective way to promote price stability. The speakers at this conference have been asked to discuss the role of monetary policy in allocating credit. In this regard, I would like you to keep in mind the proposed distinction between monetary policy and credit policy. My opinion is that ideally monetary policy should not be used to direct credit allocation. The probability is high that if central bank credit is used to support specific areas of the economy, pressure to obtain central bank financing will mount, making it more difficult to conduct the central bank's operations in a manner consistent with price stability. This is not to imply, however, that direct credit allocation is altogether undesirable. Credit policy, which is wider than monetary policy in the sense that the former does not only refer to the operations of the central bank, may well consider some direct credit allocations by institutions other than the central bank. Direct credit allocation has been criticized since it has frequently involves interest rate subsidies, which are difficult to justify. Neverthe- less, direct credit allocation does have a raison d'etre. Commercial bankers, just like many other people, are sometimes reluctant to adopt new ideas. They may believe that granting certain types of credit or financing certain areas of economic activity is extremely risky. Yet this may not be the case when the appropriate credit techniques are applied. In such circumstances, the demonstration effect that can be provided, say, by a development bank is extremely useful. It seems to me that the most important reason for development banks to exist is the role they can perform as credit innovators and as instructors for the commercial banks and perhaps also for the securities houses and other financial intermediaries. This is why, as commercial banks and other financial intermediaries become more experienced and imaginative, the need for direct credit allocation and for development banks fades away. This has been the experience of the industrial countries. But please do not misunderstand me. The disappearance of development banks is by no means an immediate prospect. For developing countries, development banks—the World Bank included—will continue to play an important role for a long time.

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To be efficient, direct credit allocation has to be limited. If extensively applied, it can cause more damage than good. This is because it is virtually impossible to determine the amount of credit that should be rationally allotted to each branch of economic activity within the limited total amount of resources available. The credit allotted to a certain activity may be excessive, and as a result some part may remain unused, whereas credit allocated to another activity may be insufficient, posing an undue constraint on its development. On the other hand, since credit tends to move as if within communicating vessels, enterprises with the ability to borrow the excess credit allotted to them will become lenders to enterprises suffering from credit shortages. Although this may, indeed, be good for the economy, the purpose of direct credit allocation will be defeated. Moreover, this kind of allocation appears harmful, as it creates the need for a greater degree of credit intermediation than would otherwise be necessary. Let me now make some comments on the relationship between monetary policy and fiscal policy. The action of the central bank with regard to the prevailing fiscal policy will depend to a large extent on the degree of the central bank's independence. There are unfortunate situations—which are not infrequent—where monetary policy virtually cannot exist, since the central bank must accommodate the government's demand for credit, no matter how large it may be. In such cases, one of the few constructive measures that the central bank can take—if allowed—is to implement a foreign exchange policy conducive to avoiding abrupt exchange rate fluctuations and major disruptions in the balance of payments. Assuming the central bank enjoys a degree of independence, it can design monetary policy to compensate for certain actions of fiscal policy. For instance, if the government is running a surplus and deposits the surplus funds in the central bank, the latter could well provide credit to the market to compensate for the money-sterilizing effect of the deposits received from the government, and vice versa, if the government withdraws money from deposits in the central bank, the latter probably should absorb liquidity from the market. By intervening in the credit market, the central bank has the ability to smooth out undesirable fluctuations of liquidity and thereby of interest rates. It cannot, however, create savings nor can it borrow indefi- nitely. Consequently, the central bank cannot determine the level of real interest rates at will, except for relatively short periods of time. Thus, if saving in a country is small while the borrowing requirements of the public or private sector are large, real interest rates are bound to be high even in the long run even if this can be avoided in the short run through central bank action. Moreover, nominal and real interest rates

©International Monetary Fund. Not for Redistribution lean Godeaux 23 are likely to end up even higher if central bank actions bring about inflation. We have already discussed this when referring to the ex ante and ex post interest rates. To end this presentation, I would like to make a few comments on foreign borrowing and monetary policy. The effects of foreign borrowing depend on the nature of exchange rate policy. If there is a floating exchange rate, the inflow of capital will tend to appreciate the domestic currency and this, in turn, will tend to discourage exports and to stimulate imports. Monetary aggregates, however, need not be affected. On the contrary, if there is a fixed exchange rate or a crawling peg, then the inflow of capital will cause the monetary base to expand. If the inten- tion is to take advantage of the inflow for increasing international reserves, the monetary effect of the inflow should be compensated for by means of reducing the credit of the central bank to the market. This will bring down the monetary base to where it was prior to the capital inflow. But if foreign borrowing is to finance development, the monetary aggregates should be allowed to increase so that demand is stimu- lated. As a consequence, imports will grow while exports may decline and more foreign currency will be demanded from the central bank. Consequently, other things being equal, we should expect the monetary base to go back to where it was at the beginning. Monetary policy can take many courses depending on the circumstances of the public finances and of international capital flows. At all times, however, the monetary authorities should see to it that their actions contribute to monetary stability.

JEAN GODEAUX

1 am speaking to you this morning against the background of the benefits and possibly the biases of two recent experiences. In recent months, I was, as were all the governors of the central banks of the European Community (EC) countries, a member of a committee that was set up by the European Council, under the chairmanship of the President of the Commission, Jacques Delors. With the assistance of another member of the commission and of three independent experts, all seventeen of us acted in our personal capacity and were asked by the European Council to study and propose concrete stages leading toward economic economic and monetary union in the Community. At the same time, in my own country, the Government and Parlia- ment were changing the constitution in order to move from a basically unitary state to a federal type of state. Among the tasks that were, in these circumstances, entrusted to the central bank was that of detailing for our politicians the conditions under which the decentralization

©International Monetary Fund. Not for Redistribution 24 ROLE OF MONETARY POLICY could be made compatible with the maintenance of the monetary unity of the country. We had, therefore, on the European level, to discuss how starting from diversity we would move to unity, and, on the national level, how we would have less political unity but keep monetary unity. The two reflections were very complementary. We had to ask ourselves the same questions on the European level and on the national level. The formulation of monetary policy, the determination of intermediate objectives, and the instruments of monetary policy do indeed vary according to the size of the economy, to the openness of the economy, to the relative importance of foreign transactions, and, finally, to the stage of economic development that the country has reached. My direct experience comes from a small economy—the total population of Belgium is 10 million and the area of the country is very small indeed—and from a very open economy. There are, as you know, various ways for statisticians to measure the openness of an economy. We may take imports as a percentage of total final expenditures in the economy. In Belgium, this percentage is about 45 percent; in the Federal Republic of Germany, France, and the United Kingdom, it is on the order of 20 percent. By comparison, in the United States, it is on the order of 10 percent. As for the stage of development, we do belong to the industrial countries. With what is now Czechoslovakia, we were, after England, the first countries to experience the nineteenth century industrial revolution. This means that we are facing the problems of mature economies. These problems are well known. We have to adjust to the profound changes that occur in our economic structure, with heavy industry losing importance relative to new, lighter, high technology industry or services industry. That is our background. But while we are a small open economy, we are also members of a large community of 320 million. In the Delors Committee, I had to consider this enlarged dimension. What is of cardinal interest is that the Delors Report was unanimously approved. It is significant that the governors who formed the great majority of the committee could, without great difficulty, come to unanimous agreement. We can thus find in this report the common preoccupations and judgments of the governors of the central banks of Western Europe. It is important to observe that the first responsibility ascribed to the future European system of central banks was the objective of price stability. It is only subject to the foregoing that the system should support the general economic policy set at the Community level by the competent bodies. The second element of the common view of the committee was first that the central banking institution should "be independent."

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These are the two main lessons that governors together have drawn from their concrete experience. These were common lessons despite the fact that within the Community there exist substantial differences in levels of economic development between, say, on the one hand, the Federal Republic of Germany, and, on the other hand, Greece or Portu- gal. Even for countries for which economic development remains a paramount priority, it was felt unanimously that price stability was, as was eloquently explained by Mr. Mancera, a condition for achieving this economic development. I believe that we can characterize the thrust of the Delors Report by underlining three words, three concepts that give color to the whole report. The first is plurality. Plurality means that we are very much aware of our differences within Europe, and that in a certain sense, these differences can be an advantage if they are reconciled with the level at which greater unity is necessary. The second consideration is illustrated by the word subsidiarity. It is now part of the vocabulary of the Community to speak of the principle of subsidiarity, according to which the functions of higher levels of government should be as limited as possible and should be subsidiary to those of lower levels. For the purpose of our present conference, it is indeed important to distinguish in the field of monetary policy what can be decentralized and what by necessity must remain central. This I believe is a central issue, especially for this immense country of China with such a large population, large territory, and certainly great local differences in the degree of economic development. The third important word is of less significance in this framework— still I might mention it—it is what we call parallelism. Ever since 1958, there has been a debate between the "economists" and the "monetarists." The monetarists have been urging the use of the powerful lever of monetary unification to force the convergence of economic situations and policies. The economists have been arguing that we should first have sufficient economic convergence and that monetary unity would be the final achievement, the crowning element, of the whole construction. What the Delors Report stated was that we must move, in parallel, on both fronts. A short passage from our analysis of the experience of the European monetary system shows the contribution that monetary policy can make to economic convergence. One sentence states that "the exchange rate constraint has greatly helped those participating countries with relatively high rates of inflation in gearing their policies, notably monetary policies to the objective of price stability." Another sentence says that in part "the success of the EMS can be attributed to the participants' willingness to opt for a strong currency stance." And in passing,

©International Monetary Fund. Not for Redistribution h6 ROLE OF MONETARY POLICYgggggggfr the report unanimously pays homage to the beneficial role played by the deutsche mark, as an anchor of the common policy that is being pursued within the European Monetary System. I would like to end with one conclusion. To be effective, a central bank must be autonomous, but what is the basis of this autonomy? What is the real foundation for this autonomy? It is not so much the institutional aspects but the confidence that the central bank inspires— a confidence that rests upon the quality of the analysis that the central bank is able to make of the country's situation and the nonpartisanship of the advice that the central bank gives to the government. In my particular experience during my tenure as Governor there were four successive ministers of finance, three of whom belonged to different political parties. I was pleased and impressed that at the end of my mandate, during a farewell party, these four ministers wanted to under- line that I, and the Bank, had been telling them the same thing regard- less of their own political preferences. Technical competence and nonpartisanship, perceived by public opinion, are the two foundations of the autonomy of the central bank. Autonomy is, in turn, the foundation of the bank's effectiveness.

SUMMARY OF DISCUSSION

RICHARD D. ERB First, let me say that the speakers spoke from a diverse set of circumstances and experiences, but there was an interesting consensus on some key issues. First of all, speakers recognized that multiple objectives—growth and development, full employment, balance of payments stability, price stability—face each government; Mr. Mancera reminded us that income distribution is also important. With respect to the role of the central bank, Mr. Mancera put it in an interesting way. He said that we all share these objectives and the real question is in what way can the central bank make its most effective contribution. This leads me to the next general conclusion and that is with respect to the role of the central bank. We heard from all speakers that the primary emphasis, the priority, should be given to achieving price stability; this is a way to achieve the conditions necessary for saving, investment, and exchange rate stability—all of which can contribute to economic growth. I thought that Mr. Mancera also very graphically described what happens when a government loses control over inflation. A third point was that monetary policy implementation and the success in achieving price stability, and the other objectives, depend importantly on the structure of the economy and other policies. As it

©International Monetary Fund. Not for Redistribution Summary of Discussion 27 was put, good monetary policy is a necessary condition; but it is not sufficient. Other factors influencing the impact of monetary policy include the degree of price and wage flexibility, the private saving rate, other government policies, and, in particular, fiscal policies. This leads me to what I think is the next major issue: What should be the relationship between fiscal and monetary policy? As each of our speakers pointed out, excessive fiscaldeficit s can make monetary policy more difficult, can crowd out other productive investments, and can result in too much domestic and external borrowing. With respect to what is an ideal relationship, some observations were made that both the central bank and the finance ministry, if they are the relevant fiscal institutions, should have considerable status in the government. Sec- ond, on the fundamental issues of the performance of the overall economy, those two institutions should be natural allies. At the same time, it was recognized that there may be times of open conflict between the two institutions. Another general point of discussion concerned the role of the central bank in credit allocation. Here, I thought that there was a strong view among the speakers that the central bank should not directly involve itself in credit allocation. Many reasons were cited. For example, it is difficult to decide who should get the credit; too many risks are involved, including, in particular, the direct involvement of the central bank in credit allocation, which may undermine the ability of the central bank to control overall credit. Another aspect of the issue of credit allocation that was discussed was the question of the overall role of the government in credit allocation. To the extent that there is involvement, it should be more specifically carried out through the budget. But I think all speakers recognized that the degree of direct credit allocation depended on the structure and objectives of each economy. Let me just mention a couple of other issues that I am sure we will come back to in later sessions. The first issue concerns the importance of explaining monetary policy to other parts of the government and the general public. Another is the question of the degree of autonomy of the central bank. Other issues include the question of subsidiarity and what should be centralized—what functions should be centralized and what functions decentralized—and also the question of continuity and stability in policy implementation. Finally, I would like to come back to Mr. Volcker's statement that both the central bank and the finance ministry should have considerable status in the government and discuss more precisely what that means.

©International Monetary Fund. Not for Redistribution Session II Implementation of Monetary Policy

ZHOU ZHENGYING

hkkkk My presentation focuses on the way the central bank uses instruments of monetary policy to achieve the desired targets of monetary policy. The choice of instruments of monetary policy is closely related to the economic management system, the financial system, and the sophistication of a market in a given economy. The difference in these areas underlines the difference in the choice of the instruments of monetary policy and the function they can play. Generally speaking, the central bank has at its disposal three main policy instruments: the reserve-requirement ratio, the rediscount rate, and open market operations. The reserve-requirement ratio is one of the most powerful instruments that the central bank can use to control the monetary and credit aggregates. In China, such an instrument is geared toward readjusting the credit structure. The reserves lodged at the central bank are reallocated to the specialized banks in line with the industrial policy set by the state. The rediscount rate or the central bank's lending rate, a typical instrument for economic regulation and adjustment, is different from the reserve-requirement ratio in that it controls and adjusts the monetary and credit aggregates and their structure chiefly through affecting the cost of funding for borrowers. Therefore, on the one hand, it is a macroeconomic instrument for controlling and adjusting the monetary and credit aggregates; on the other, it facilitates the efficient allocation of financial resources in an economy. Open market operations refer to the central bank's purchases and sales of short-term government securities in the financial market to affect the monetary base and the money supply. They are very flexible compared with the reserve-requirement ratio and rediscount rate. Thus, they have become the day-to-day policy instruments, but they require

©International Monetary Fund. Not for Redistribution Zhou Zhengying 29 the existence of fairly developed financial markets and a large amount of eligible securities for trading. That is the reason why many developing countries with underdeveloped financial markets are still unable to make use of open market operations. Apart from these three traditional instruments, a large number of countries have some other approaches to control money and credit. These include ceilings, loan/capital ratios, interest rate ceilings, moral suasion, and window guidance. Experience in various countries has proved that through the implementation of a combination of the three major policy instruments and other supporting credit control mechanisms, the central bank is able to function effectively in strengthening the ability to exercise macroeconomic control and adjustment. For a long time in the past, the execution of China's monetary policy depended on the highly centralized plans for credit and cash. The restructuring and reform of the economic system has included in the financial sector the use of reserve requirements and the central bank's refinancing facility and refinancing rate, for example. Today, China relies on the following four instruments for the implementation of monetary policy: Guidance plans for credit and cash—Under the prevailing central bank system, these two plans still function as the effective instruments for controlling money and credit. Despite the fact that some of the targets are no longer in the category of guidance management, these two plans form the basis for macroeconomic regulation and adjustment of money and credit, since the targets under the plans are formulated under the state plans for production, investment, and commodity circulation. The reserve-requirement ratio—The reserve-requirement systems adopted in 1984 when the People's Bank of China began to perform exclusively the role of a central bank. As further efforts were made to separate the central bank's accounts from those of other specialized banks, to separate the credit plan from the funding plan, and to intro- duce deposit-related lending in the area of credit management, the reserve-requirement ratio has become an important instrument for readjusting the credit structure in our economy. The central bank's refinancing rate—Given the fewer fund-raising operations of enterprises through bill discounts, the central bank mainly finances the specialized banks by providing credit loans. In this connection, the central bank's refinancing rate is similar to the rediscount rate in terms of macroeconomic regulation and control. With the economic reform, the enterprises and specialized banks have come into a closer recognition of economic efficiency, thus enhancing the role of lending rate as a macro-regulating instrument affecting the funding cost.

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The central bank's lending quotas—Chinese financial markets aar from being fully developed. Since the conditions for direct open market operations are insufficient, the changes of the central bank's monetary base are achieved mainly through the central bank's lending operations. The provision or recall of loans can directly influence the availability of money and credit in the system. Thus the distribution of the central bank's lending quotas has become an underlying instrument of monetary policy. Such distribution, flexible in terms of quantity, regional demand, and maturity, is the day-to-day instrument of monetary policy in China. In general, when using the foregoing policy instruments, one should take into consideration their different characteristics so that the instruments will function well together and obtain the desired targets in the process of effectively controlling money and credit aggregates. Given the close relationship between the exchange rate, foreign debt, foreign exchange reserves, and the money supply in an economy, the central bank attaches great importance to the management of the exchange rate, foreign debt, and foreign exchange reserves in the implementation of monetary policy. A description of our management policies follows. The central bank in China adjusts the renminbi exchange rate on the basis of the purchasing power of renminbi compared with foreign currencies, our balance of international payments developments, foreign exchange reserve position, and the exchange rate fluctuation in international financial markets. Because of the high inflation rate in recent years and the impact of an exchange rate realignment upon the domestic price level, and other factors concerned, we did not adjust the unreasonable exchange rate until recently. On December 16, 1989, in an attempt to address the overvalued renminbi exchange rate, we de- preciated the renminbi by 21.2 percent; consequently, other foreign currencies rose by 26.9 percent. The adjusted exchange rate regime is conducive to the growth of production and increased economic and trade contracts with other countries. In the future, we will study further the issue of exchange rate readjustment and try to create favorable conditions for a reasonable exchange rate regime. Our foreign indebtedness has been high since 1979—especially since 1985. The nation's total external debt outstanding at the end of 1987 was nearly twice as much as that at the end of 1985. It reached $40 billion at the end of 1988, an increase of 32.4 percent compared with the end-of-year figure for 1987. A few points are worth mention- ing in this regard. (1) We have borrowed from various sources and in various forms. In our external portfolio, long-term concessional loans from foreign governments and international financial institutions re-

©International Monetary Fund. Not for Redistribution Zhou Zhengying 31 present 27.2 percent, commercial lending and buyer's credit from foreign commercial banks and financial institutions, 38.8 percent, and bond issues, 15.4 percent; the rest are overseas foreign exchange deposits and financial leasings. (2) The composition of our external debt is dominated by U.S. dollars and Japanese yen. (3) The maturity and allocation of external borrowing are arranged to the advantage of external financing. By the end of 1988, short-term borrowing accounted for 18.3 percent of the total debt outstanding. The medium-term and long- term borrowing chiefly finances the growth of transportation, energy supply, machinery industry, chemical industry, production of textiles and other light industrial goods, and the development of agriculture, animal husbandry, and fisheries. Experience has proved that external financing has facilitated the buildup of infrastructural sectors with large imports of advanced equipment and technology and has enhanced the growth of the nation's key projects and the quality of products and their export competitiveness. In the management of foreign debt, the principle of a division of responsibility under unified leadership will be pursued further. Guided by enhanced management and stepped-up control, efforts will be made to keep a watchful eye on total indebtedness and its structure, to track closely the lending markets, and to strengthen control over total external borrowing. In addition, more work is needed to improve the existing system of collecting and monitoring debt data and to improve the analysis and forecasting of external debt so as to bring in, step by step, a scientific and standard system for debt management. It is common practice for central banks the world over to manage foreign exchange reserves. The foreign reserves of China comprise treasury reserves and balances of the Bank of China. By the end of Septem- ber 1989, our foreign exchange reserves were $14.2 billion. As the next step, the central bank will strengthen its management of reserves in terms of safety and rate of return and efforts will be made to readjust currency composition of reserves in a timely manner and to effectively reduce exchange rate exposure and at the same time ensure the international payments of the state. China has already set up its financial system, which is composed of a central bank, four specialized banks, and a variety of nonbank financial institutions. Progress has been made to develop the financial market, and policy instruments, such as the reserve-requirement ratio and the central bank's financing rate are playing an increasing role in macroeconomic control and adjustment. Insufficient conditions for the effective operation of those instruments has, however, to a certain degree, eroded their effectiveness. For instance, because the specialized

©International Monetary Fund. Not for Redistribution 32 IMPLEMENTATION OF MONETARY POLICY banks are unable to balance their sources and uses of funding, an increase of required reserves is more often than not reallocated to the specialized banks in the form of short-term lending, thus, the desired result of the retrenchment policy is severely affected. Furthermore, because of the insensitivity toward interest rate change, the rise in the central bank's lending rate can hardly, in most cases, effectively contain the excessive demand for credit. Therefore, in order to bring the role of policy instruments into full play, there is a need to better pursue the facilitating reforms in the financial industry. These reforms would include (1) increasing the awareness of specialized banks of the need to balance their funding operations themselves and to reduce their overdependence on central bank financing when they face a funding shortage; (2) developing a financial market to promote funding activities through the use of securities, so as to gradually reduce the overdependence on credit lending and create conditions for open market operations; (3) strengthening the operational management of specialized banks and the gradual introduction of the risk-management mechanism to their lending operations, so as to increase the efficiency of their loans and augment the role of interest rates in controlling and adjusting the credit demand; and (4) strengthening the management of external debt and following closely the effect of changes in the balance of international payments on the domestic currency. To sum up, efforts should be made to intensify economic reform, and, on our part, the reform in the financial sector, and to improve conditions for the implementation of monetary policy instruments and macromanagement of currency and credit.

PAUL A. VOLCK fa 1 sense that we have begun moving from the abstract to the practical questions faced by a central bank. We are asked to get more specific: What is a central bank supposed to do? How does it go about doing it? My sense is that as the questions get more specific they get more difficult. Accordingly, my answers will get shorter. I suppose that Governor Li has to go to the office every day and ask himself, and ask his colleagues in the People's Bank, what to do. He then has to go to the State Council, or elsewhere, and convince other officials that he knows, and the People's Bank knows, what is best for China and that his proposals make sense; he needs the tools necessary to carry out his intentions. I am not going to talk much about the tools because in that sense our approach in the United States is necessarily quite different from yours here. We carry out monetary policy essen-

©International Monetary Fund. Not for Redistribution Paul A. Volcker 33 tially through open market operations, which is the most indirect way of approaching a problem. You are dealing essentially only with treasury securities in a very well-developed and personal market; it removes all those decisions of who gets affected and how. Through open market operations, we affect the money supply and its growth and interest rates, but we do not interact with particular institutions. We interact with the market as a whole. With a quite differently developed market in China, you necessarily put more reliance upon discounting, rediscounting, and lending; that is not necessarily less efficient, although it does raise questions about—for better or for worse—credit allocation. However one approaches the question of how precisely one imple- ments policy, there is one point I feel quite certain about. It seems to me that in the conduct of monetary policy a special institution that we call the central bank needs to take the lead, and to take the lead it needs to be a strong institution. I do not necessarily say independent; practices vary quite a lot in terms of form and legal independence among developed countries. But I do emphasize that whatever the legal for- malities, it needs to be strong and influential. It seems to me, strength and influence are nothing you can necessarily legislate or command. It depends upon performance; it depends upon performance that over time results in prestige and standing and respect. We are talking about somewhat intangible matters of competence and confidence, but central banks in the Western world are typically characterized by a high degree of professionalism and continuity in their operations, whatever their precise legal situations. In the West, we would typically say their management is nonpolitical. I am not sure that that particular description is exactly appropriate for China, where competition between political parties is not the same. But let me emphasize, in that connection, that it is a fact of life that an influential central bank, a prestigious central bank, can be a great asset internationally. Mr. Mancera referred, I think, to the status of the Mexican central bank, and, if I understood him correctly, he said it was not independent. It is not independent in a formal, legal sense. But I think that I can report to you without fear of contradiction that the Bank of Mexico and Mr. Mancera have a great deal of influence, not just in monetary policy but in the economic policy of Mexico, generally. They are independent in a functional sense, and everybody knows it. That is a very considerable asset in my opinion to the Government of Mexico in dealing with the rest of the world, because there is a certain inherited confidence and trust in dealing with the central bank that frankly may not apply in the same degree to the rest of Mexico—and I am not making a particular point about Mexico. We see in country after

©International Monetary Fund. Not for Redistribution 34 IMPLEMENTATION OF MONETARY POLICY country, particularly when one is dealing with foreign creditors, that a special degree of confidence often resides in the obligation of a central bank, because it is felt to be an institution with special continuity, a special nonpolitical character, a special ability to carry out its obligations. One should think about that dimension when considering the role of a central bank in any country, particularly a developing country that wants to rely upon external credit. The second area is how to conduct policy in terms of what one actually looks at, when one comes to the office in the morning and decides what to do. It is fine to talk in vague abstractions about stability and growth and employment and balance of payments, but what does that tell you to do on Monday morning, January 15, in terms of operations. Is there a more or less fixed rule? Can we look in the book in the morning and look at the rule and look at the markets? Can we look at what is happening in some market or another or at some number or another and have it tell us what to do? Let me suggest some of the indicators that have been talked about and used to some degree. The most popular one is some measure of the money supply. Unfortunately, most countries have several measures of the money supply, but one strong view in central banking says that what you do in the morning is determined by how the money supply looks and what your objective is for the money supply. Another approach might be to look at interest rates and say that by and large interest rates ought to be positive in real terms in order to attract savings and provide stability; so let us look at interest rates and let us look at prices every day and see what are the policy implications. Another approach is to look at the exchange rate or, if the exchange rate is fixed, to look at what is happening to international reserves. If the exchange rate is appreciating, it is time to ease; if it is depreciating, it is time to tighten up; or, if reserves are rising, ease up; or, if reserves are falling, tighten up. That is not such a strange rule when one con- siders that that is what the gold standard amounted to—that was a very popular rule, fifty years ago, a hundred years ago. Or, one can look to the end objectives of policy and look at what is going on in prices or look at what is going on in production and make a policy conclusion, based upon whether prices are going up or down or how fast they are moving. All those have certain attractions, but they all have certain difficulties. I can only speak from my own reaction in the United States and from the responsibilities I once had in the United States. Speaking from that experience, I can say that none of those single rules applied me- chanically seemed very satisfactory. I felt at that time, at least, and I think it is quite clear this is the way the Federal Reserve is conducting

©International Monetary Fund. Not for Redistribution Paul A Volcker 35 policy today, that they are relying upon a fixed rule in none of those respects to conduct policy and that indeed policy is conducted on the basis of an evaluation of all those factors and some practical pragmatic judgment, reached from day to day or week to week or month to month, about what the implication is for easing or tightening policy. That statement does not get you very far because it sounds very sensible; it is also a good way to make mistakes. Given the lags and uncer- tainties that I spoke about this morning, you cannot tell from looking at the market today, or looking at prices today, or looking at production today what the implications are for policy, because today's policy may affect prices a year from now, or production six months from now. In this situation, and depending upon a particular country or a particular time, it has often been useful to give perhaps a little more weight to one or another of the indicators that I spoke of, indicators that react more quickly. The favorite ones have typically been the money supply or the exchange rate or some combination of the two. They are measures that more sensitively reflect what is going on, first of all in the markets today, and second, if maintained in some kind of steady and predictable way, tend to keep the economy reasonably on course over a longer period. We were quite insistent for a time, ten years ago in the United States, upon guiding the money supply in accordance with some predetermined levels. But the relationship between the money supply and economic activity and the money supply and prices demonstratively became a lot more uncertain, a lot more volatile. I do not know enough about China, but it may be that in a developing country of this sort, with less developed markets, and less alternatives in the form in which money is held and liquid assets are held, the relationship between the money supply and the real economy and the money supply and prices may be a lot closer than in the United States. If so, that would certainly be an argument for putting, among all the factors, a certain amount of weight on money growth over a period of time in determining policy. One word of warning in that respect: a stable relationship does not necessarily mean a constant relationship. In a sense, particularly in a developing country, you may find that the growth of the money supply is rising quite normally, more rapidly than the economy, as the economy becomes more and more financially oriented as it grows. As the banking system grows, there may be room for monetization of the economy, which leads to more rapid growth in the money supply, as we measure it, than in economic activity. But that is a judgment that can only be reached by very close and careful study of the experience in any one country. For three or four decades, we had the opposite situation in the United States; as the markets developed more and more outside the

©International Monetary Fund. Not for Redistribution 36 IMPLEMENTATION OF MONETARY POLhhhhhg banking system, the growth in the money supply was slower than the GNP; so it depends very much on the particular circumstances in a particular country.

MIGUEL MANCERA d If there is a central bank in a country, it would seem obvious that it is the institution that should implement monetary policy; however, this is not always the case. There may be situations where another authority—for example, the ministry of finance—issues the relevant regulations and instructs the central bank as to how to conduct specific transactions in the financial markets. Turning to the question of who should formulate monetary policy, arrangements vary from country to country. Usually the drafting of the monetary program is a function of the central bank. Then, if the central bank is not autonomous, the ministry of finance or the authorities may modify or entirely change the draft. In my view, no institution is better placed than the central bank to draft the monetary program. Nor is one better equipped to implement monetary policy. This is because no other authority has closer contact with the money market than the central bank. Other authorities are more distant. In some cases, they may be out of touch as far as monetary affairs are concerned, no matter how firmly they keep their feet on the ground with regard to other matters. There is another reason for entrusting the formulation and implementation of monetary policy to the central bank. In many countries this institution—fairly or unfairly—is held responsible, at least partially, for the stability of the currency either in terms of its domestic purchasing power or in terms of its rate of exchange. It has a legitimate interest in the adoption and execution of a monetary policy conducive to stability. In formulating monetary policy, the authorities must remember that that policy does not operate in a vacuum but within the realities of a given country at a particular time. Monetary policy must therefore be consistent with the expected or intended rates of growth of the economy, of prices, and of the international monetary reserves of the country. Moreover, it must take into account the likely behavior of public finances, as well as of private saving and investment. In formulating monetary policy, due consideration must be given to its consistency with a number of important exogenous elements, such as the prospective international environment, including the possible evolution of prices of imports and exports, of capital flows, and of other balance of payments items. Monetary policy should not, however, be simply made

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to fit in a given context; it can be used to influence and modify that context. Specifically, it can be used to fight inflation and to determine balance of payments results; however, it is not always successful in achieving these goals. One of the main reasons why monetary policy may not succeed is that in many cases fiscal policy may limit central bank action. Let us assume a country—not difficult to find—where the domestic public debt is large, fiscal deficits enormous, and inflation high. It is conceivable, at least theoretically, that inflation could be stopped within a rather short time should the central bank bring the growth of its domestic credit to a halt (assuming, for the sake of simplicity, that the external sector behaves naturally). Why then are central banks unable to stop inflation in many instances? The most likely answer is that the government of the country in question is not able to borrow from the market the amount needed to fund its deficit. In principle, as the government becomes unable to finance the entirety of its expenditures, some of them should be cur- tailed. Everyone knows, however, that in reality this can be done only to a limited extent in the short run. Large-scale cuts imply, for instance, laying off an enormous number of employees or interrupting the service of the public debt. Both courses of action may inflict more damage on the economy and on the population than inflation itself. Yet it is also true that if inflation is not fought, albeit gradually, it is very likely to go out of control, to the point where the economy collapses. From what I have said, it becomes clear that if monetary policy is to succeed in stabilizing prices, the public deficit cannot be larger than the amount fundable with real savings plus the amount of primary credit, that is, the credit of the central bank that may be created without producing inflationary pressure. Indeed, some primary credit can be created in this fashion, provided there is also an increase in the demand for monetary assets. Usually this increase comes naturally as the economy grows and as it passes from self-sufficient units to a wider division of labor and as it evolves from barter to the general use of money. In the presence of a large fiscal deficit that cannot be financed without resorting to excessive primary credit, stopping inflation is, as far I know, impossible. This is why stabilization programs must include or be preceded by the correction of public finances. Correction of public finances, however, even their full equilibrium, cannot by itself guaran- tee that inflation will be stopped. This is because other sources of expansion of the monetary base might still be present, notably excessive central bank financing to the private sector. To achieve and maintain price stability, not only the monetary base but also the domestic credit of the central bank must not expand in a

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measure inconsistent with the real increase in the demand for the notes and deposits constituting such base. If domestic credit increases excessively and continuously, international reserves will diminish until devaluation becomes unavoidable. In the background paper prepared by Mr. Balino, of the IMF, for this conference, there is an excellent discussion on the roles, merits, and demerits of the various instruments available to a central bank in implementing monetary policy. It would be pointless for me to say in different words what has already been well explained in that paper. I should simply state that I entirely agree with the views there expressed. Nevertheless, it might be useful to share with you some experiences that we have had in Mexico with some of these instruments. Before telling you about them, I would like to point out, however, that the effectiveness of a particular instrument depends very much on the breadth, depth, and degree of sophistication of the financial system. Some instruments are very effective in little developed financial systems and less so in more developed ones; whereas the opposite applies to other instruments. When banks or similar institutions are the only significant component of the financial system, some measures, for instance, changing reserve requirements or setting credit ceilings, may be very effective, albeit harsh. However, if, for example, very high nonremunerated reserve requirements are in force over a long time, parallel credit markets will tend to develop, rendering the regulation on bank reserves ineffec- tual. The same development occurs when credit ceilings last too long and even more so if deposit rates are also held "by decree" at artificially low levels. Reserve requirements, and to a lesser extent credit ceilings, were used extensively in Mexico for decades. However, as the financial system, both formal and informal, grew to include an increasing number of nonbank participants, the effectiveness of these instruments diminished. This was particularly true when the bank deposit rates were regulated and the central bank did not wish, or was not allowed, to let them reach a level consistent with what market conditions demanded. The loss of effectiveness of reserve requirements and of credit ceilings as monetary policy tools became very noticeable in Mexico during the third quarter of 1988, a time when bank deposit rates were held below market levels. As nonbank participants in the money market had increased in number and sophistication over the previous years, mas- sive bank disintermediation took place posing an immediate threat. Fortunately, at that stage the central bank was able to convince the other authorities involved that liberalizing bank intermediation was indispensable. Thus, deposit rates were freed (lending rates had already

©International Monetary Fund. Not for Redistribution Miguel Mancera 39 been freed well before), credit ceilings were removed, and compulsory lending to the government and to other privileged borrowers was eliminated. Reserve requirements were replaced by a so-called liquidity coeffi- cient according to which 30 percent of the total amount of deposits must be invested by banks in government paper (to be bought and sold by them in the market), or held in deposits with the Bank of Mexico, or held in cash. This far-reaching liberalization has had remarkable results. Banks have become far more competitive as the differential between deposit and lending rates is narrowing. This has not impaired the soundness of banks, as the narrower spreads are being applied to larger volumes of credit and as banks are now charging for a number of services that they were previously providing free of charge or at prices below cost. By pricing these services in a more rational way, banks cease to be the vehicles for the transfer of subsidies from depositors and borrowers to the users of such services. The liberalization of bank intermediation has not hindered the implementation of monetary policy. In fact, it is now carried out with more effectiveness by means of open market operations. But let me point out that there are at least two important prerequisites for using open market operations as an effective instrument of monetary policy. One is the recognition that interest rates must be flexible. This is an intellectual prerequisite, but one that is essential, a sine qua non. The second prerequisite is more material. It is the existence of a reasonably deep and efficient money market where treasury bills or other paper can be traded extensively. Our experience suggests that open market operations have three distinct advantages over other instruments. First, their effect is not limited only to the banking system but is felt more broadly in the financial market in general, including the informal credit markets. Second, they directly affect the monetary aggregate, which is, in my view, the most important one for purposes of monetary policy, namely, the monetary base. And third, they can be decided and carried out with extreme speed and flexibility. Monetary policy has a tremendous influence on the exchange rate. I would say that, in the long run, the most important factor in determining the exchange rate's average level is the behavior of the domestic credit of the central bank, or primary credit. If this is excessive, the population's purchasing power will tend to increase. As spending increases, imports grow and exports diminish. This situation tends to deplete the country's international reserves, so that, at a certain point, devaluation or foreign exchange rationing becomes unavoidable. After

©International Monetary Fund. Not for Redistribution 40 IggggggggENTATION OF MONETARY POLIf this outcome, the inflationary pressure that might have already existed is exacerbated. Let me reiterate that primary credit should be managed in a manner consistent with price stability. If this principle is observed, we can expect the rate of exchange of the national currency to other major and stable currencies to not vary abruptly, except when international reserves are so low that the daily or seasonal imbalances of demand for and supply of foreign exchange cannot be compensated. What should the central bank do with regard to exchange policy if for one reason or the other it cannot manage primary credit in a manner consistent with stability? In this circumstance, it seems to me, the lesser evil is to adopt a crawling peg, that is, a scheme of daily small devaluations. This scheme is preferable to abrupt devaluations from time to time, because the behavior of the exchange rate is more predictable from day to day. Thus, a consistent relationship between domestic and foreign interest rates can be established. Abrupt devaluations of the currency are very harmful. They create an environment where consistency between domestic and foreign interest rates is difficult to achieve. As a consequence, speculation increases and short-term international capital flows may have a de- stabilizing effect on the domestic economy. Ex ante interest rates diminish even if ex post rates go up. Thus, saving is discouraged by the low ex ante rates, while servicing debts becomes more costly owing to the high ex post rates. These problems clearly appear in countries where there are no controls on international capital movements. Yet even where these controls exist, similar problems may arise, for instance, through "leads and lags" in import payments and export receipts. International capital flows, fortunately, are not only of a specula- tive nature, a good part of them also responds to direct foreign investment decisions or to borrowing by domestic entities to finance the expansion of production facilities. The central bank's action in respect of these flows depends on many variables. Generally speaking, however, it could be said that if a sudden large inflow of capital appears, which is not largely destined to the importation of equipment or other goods, the central bank would be well advised to sterilize a part of the monetary expansion caused by the inflow. Otherwise, inflationary pressure is to be expected as a consequence of excessive expenditure. Over time, the central bank could gradually reverse its sterilizing action so that the economy uses the added purchasing power that the inflow of foreign savings can provide. International capital movements can be managed not only through indirect measures, such as market transactions carried out by the central bank, but also by means of direct regulations or controls.

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Since international capital movements may have a strong impact on monetary aggregates, the central bank should have at the very least an advisory role to the authority empowered to regulate such movements. It is logical that foreign borrowing by public sector entities should be approved by the financial authorities, since the government is normally held responsible, de jure or de facto, for the service of the respective debts. If foreign borrowing by private firms is free, it should be made absolutely clear to the lenders that the government will not bail out the debtors should they be unable to pay. The role of the central bank in managing external reserves is two- fold. First, the central bank must seek the best possible combination of security, yield, and liquidity of the assets constituting such reserves. Second, and more important, the central bank, through monetary policy measures, should determine the total amount of external reserves most appropriate in each circumstance. These are difficult tasks as they often clash with other economic policy objectives.

JEAN GODEAUX

a 1 stated this morning that the formulation of monetary policy and the selection of an intermediate target by implementing monetary policy varied according to the size of the economy, the degree of openness of the economy, and the state of development of the economy, but that, whatever these variations, the essential goal remained that of price stability. When it comes to discussing, as we are now, the problems of formulation, implementation, and monitoring of monetary policy, the two factors, openness of the economy and stage of development, in particular, the development of financial markets, play a decisive role. For the purpose of exposition, some professors of economics would describe an appropriate economic policy as one encompassing a magic square, one side of which is the level of output, another side is the evolution of prices, the third side is employment—or unemployment— and the fourth is the external balance. Geometrical analogies are always imperfect, as are all comparisons. I would be tempted to say that we really ought to consider a magic pentagon, because there is a fifth element, which, as we said this morning, is of paramount importance: the state of public finance. The possible influence of the central bank on these four or five elements is quite unequal. We are in the habit in our country of thinking that an adequate financial and monetary policy should be achieved by a good working relationship between the central bank, the ministry of finance, and the banking commission (in our country the supervision of banks is entrusted to a separate body, in

©International Monetary Fund. Not for Redistribution 42 IMPLEMENTATION OF MONETARY POLICY which the central bank is importantly represented). The influence that the central bank may have within this troika depends on its autonomy, which in turn depends on its professionalism, on the prestige which it enjoys. All these determine the leadership that the central bank can in fact exercise. For the implementation of monetary policy in our country and, more and more, in practically all European countries that are members of the European Monetary System (EMS), the most important intermediate target is the exchange rate. Therefore, the thing we look at every morning, when we arrive in our office, is the exchange rate and the situation of the foreign exchange market. Immediately after that, interest rates, and in particular, interest rate differentials are the most important factor. To the extent that the foreign exchange risk is perceived to be decreasing, interest rate differentials exert a greater influence on movements of funds across borders. This adherence to the stability of the exchange rate as an intermediate objective of monetary policy and the confidence that it can inspire in the minds of the market operators can have a very important effect on the economy. In 1982, we had to face a situation in which, to keep an acceptable position in the EMS, Belgium had to have short- term interest rates 5 1/2 percent higher than the Federal Republic of Germany. When I left my office, this differential had been reduced to 1 3/4 percent. This was made possible because of the improvement in the general economic situation, thanks to the policies pursued by the Gov- ernment, and as a result of the central bank's policy aimed at building confidence in the stability of the currency. Much of what I have said is of limited applicability to China because conditions are different in many respects. But the core of my testimony is, I believe, valid.

SUMMARY OF DISCUSSION

RICHARD D. ERB This afternoon's discussion made us realize that the important policy decisions have to be made on a day-to-day basis. Often they must be made without adequate information or complete information and sometimes with conflicting information. Although there is a clear consensus on the importance of setting longer-term targets, such as price stability, intermediate targets are also necessary. Those intermediate targets could be money supply, perhaps interest rates, industrial production, exchange rates, or reserves. The choice of an intermediate target will depend on each country's circum-

©International Monetary Fund. Not for Redistribution Summary of Discussion 43 stances, and the use of an intermediate target cannot be done in a mechanical way; a judgment is required. Picking up on a point that was made this morning, that is, that it is important to think about monetary policy in a medium-term framework, all of the speakers stressed that it was important to have a medium-term framework for targets that would be used for guiding day-to-day decisions. That in setting a medium-term framework, a target, for example, the money supply, should be chosen that is generally understood. The medium-term path for the targets could be set at a particular time, say, at the beginning of the year. The targets would then be set in the context of a broader economic plan, and during the course of the year the actual performance can be measured against the targets. The central bank can evaluate this performance on a day-to-day basis against the medium-term plans. As Mr. Godeaux pointed out, judgments are required, and sometimes it is important to make a judgment not to stay with the original plan. There was then discussion of the instruments of monetary policy. Again, there are many different possible instruments depending on the size and structure of an economy. There are those instruments that are more direct, for example, credit ceilings; less direct ceilings, including reserve requirements, rediscount rates; and the most indirect instruments, that is, open market operations where the central bank buys and sells treasury securities. Again, the choice of the instruments depends on the size and the structure of the economy. Among the speakers, there is, again as expressed this morning, a preference for the indirect means, the indirect instruments, but an understanding that more direct approaches may be necessary in a less developed financial market. Mr. Mancera made the point that excessive reliance on some instruments, for example, credit ceilings or reserve requirements, may over time be counterproductive because it results in a movement away from financing, away from banks into nonbank intermediaries. Mr. Mancera also made a point on the question of external borrowing; he said if public sector agencies are borrowing internationally, the borrowing should be subject to approval by the government. It should be made absolutely clear to lenders that the government will not bail out the debtors should they be unable to pay. There were some other themes discussed, including the importance of explaining monetary policy decisions to other officials, the business community, and the general public. Tomorrow when we talk about the role of the central bank, we can give more specific examples on how different governments develop a medium-term plan. Another question that we could discuss tomorrow is whether a central bank has a role in promoting the deepening of

©International Monetary Fund. Not for Redistribution 44 IMPLEMENTATIhON OF MONETARgggg financial markets. I raise that question, because our speakers had a clear preference for the indirect means of managing monetary policy. But the more indirect means requires more well-developed financial markets.

©International Monetary Fund. Not for Redistribution Session III Role of Regulation ah Supervision of the Central nk

TONG ZENGYIN ad Supervising and regulating the operation of financial institutions are the important functions of the central bank. Only when the power of supervision and regulation is properly pursued and supervision and regulation duly performed can the financial sector play its role fully in macroeconomic regulation and control and monetary policy targets be smoothly realized. All central banks in the world have therefore paid much attention to supervision and regulation, established special departments, and provided enough staff for this purpose. Our central bank is no exception in that it has also laid strong emphasis on supervision and regulation. The People's Bank of China began its function of supervision and regulation over financial institutions with the financial reform at the end of the 1970s. The history of supervision and regulation in the past four decades can be broadly divided into three periods: The first is from the foundation of new China in 1949 to 1978. There was one state bank throughout the country with dual functions both as the central bank and a commercial bank so as to adapt to the highly centralized planned economy. Being only a cashier to the Minis- try of Finance, the People's Bank of China was actually paralyzed in exercising its power of supervision and regulation. The second period is from 1979 to 1983. In addition to the role of central bank, the People's Bank of China was also responsible for some of the functions of specialized banks, due to the fact that the economy was in transition from a centrally planned economy to a planned commodity economy. In this period, the central bank was unable to fully perform its functions of supervision and regulation because it did not have an independent role. The third period is from 1984 to the present. During this time, the People's Bank of China has been functioning solely as the central bank

©International Monetary Fund. Not for Redistribution 46 ROLE OF REGULATION AND SUPERVISION OF THE CENTRAL BANKllllllllllll and no longer handles specific banking business. It has fully played its role of supervision and regulation in accordance with state rules, regulations, policies, and guidelines. As a result, a number of positive changes have been brought about in the financial system. First, stable financial order has been maintained. Through supervision and regulation, legal business activities have been protected and illegal activities eliminated. A healthy financial order has been gradually set up in which financial institutions operate with both division and coordination in business and within the specified scope of business. Second, the financial system has been perfected. The central bank controls, according to the needs of economic development, the establishment of financial institutions in order to perfect the financial system. Third, realization of monetary policy objectives has been secured. The central bank performs supervision and regulation in line with the objective of monetary stabilization. By examining the execution of plans and the implementation of monetary and credit policies and supervising the operations of financial institutions, the People's Bank of China has helped facilitate the realization of macro-adjustment objectives. The central bank ought to have corresponding power in order to supervise and regulate financial institutions. Supervisory and regulatory powers have been greatly expanded in recent years, with the deepening of economic reform and the greater role of the central bank. At present, the People's Bank of China has responsibility not only for supervising and regulating the financial institutions with respect to their internal structure, business scope, interest rate, borrowing and lending operations, etc., but also for punishing financial institutions that break rules and regulations. The imperfection of the existing financial framework, however, has severely limited the central bank's ability to carry out its supervisory and regulatory activities in accordance with promulgated rules and regulations. We are planning to solve these problems through accelerating legislation so that the central bank's supervisory and regulatory functions will be ensured. Our financial regulation system is different from that of Western countries. We have neither the Office of the Comptroller of the Cur- rency nor the National Credit Union Administration, nor the independent financial administration units. The People's Bank of China is fully responsible for supervising and regulating financial institutions. One of the advantages of such an arrangement is that it provides consistent supervision and regulation; a major disadvantage is the lack of various institutions to check and balance one another. Given the present framework, we are trying to strengthen supervision and regulation by enhancing the division and coordination of relevant internal depart-

©International Monetary Fund. Not for Redistribution Paul A. Volcker 47 merits and by the better integration of regulation and supervision; daily regulation should identify important areas for supervision; in return, supervision should identify weaknesses in the system that need stronger regulation. With respect to the integration of supervision and regulation, the following relationship should be properly handled. (1) The relation between macro-economy and micro-economy: Supervision and regulation should, on the one hand, maintain the macroeconomic stability and, on the other, prevent microeconomic activities from being overly restricted. (2) The relationship between key institutions and other institutions: Supervision and regulation should focus on those institutions with the greater volume of business and serious managerial problems without undue ignorance of other institutions. The detailed examination of one individual institution or a group of institutions should be properly integrated with the overall supervision of the whole system. (3) The relationship between persuasion and punishment: The problems found during supervision and regulation should be treated differently in consideration of different situations. Enterprises with occasional or minor regulative problems should be persuaded to correct their behavior, while enterprises with periodic or serious problems should be punished. (4) The relationship between quantity and quality: Efforts should be made to ensure that all financial institutions are under proper supervision. Meanwhile, supervisory and regulatory experience should be periodically reviewed so that their quality will be continually upgraded.

PAUL A. VOLCKER It may be useful if jjsifications and definitions. We are talking about supervision and regulation. Supervision and regulation for what purpose? There are at least three different purposes in the United States—and I suspect in most countries—and to some extent they overlap, but they are also distinct. There are certain rules and regulations that are issued primarily for monetary or credit control. They are a means of carrying out the policies that we talked about yesterday. An obvious example in this area is reserve requirements. We have rather elaborate definitions of different types of deposits in the United States, partly to keep their liquidity characteristics distinct. Well, we have abandoned them. For a long time, we had interest rate ceilings on the interest rates that banks and other financial institutions could pay to depositors, and they were at least partly for monetary policy purposes.

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All those kinds of regulations require writing certain rules, and while it is a fairly simple job, somebody has to make sure that the rules are in fact followed by the regulated institutions. In this case, it is typically the central bank that enforces those rules in the United States, although not always. A second area in which we have regulation and supervision is what is thought of as so-called prudential rules, rules involved with the safety and soundness and stability of supervised institutions. The basic purpose of these rules is to make sure that institutions are strong enough to carry out their functions in the economy, while remaining solvent and adequately liquid. This area is enforced by two different kinds of approach. Sometimes, general rules and regulations are written. You may do this. You may not do that. You may not do things that are deemed to be unduly risky. You may do things that are deemed to be appropriate and safe. But a major part of this effort is done through examinations, on-site examinations of the supervised institutions, where teams of ex- aminers from the authority go out and inspect the banks, more or less every year. The inspection is quite thorough and very detailed reports are written. Out of those reports come judgments and sometimes orders to those institutions to change their practices. A final area of supervision and regulation encompasses what might be thought of as social concerns. They are not really necessary for monetary policy; they are not really necessary for safety and soundness, although all these things overlap. But they are incurred as a result of laws passed by the U.S. Congress, typically, to reflect certain very broad social and economic concerns that the country has. I will give two kinds of example. One is certain laws that encourage or require financial institutions to pay particular attention to the needs of certain types of consumer. These are sometimes hard to define specifically, but the supervising authorities are directed to make sure that the banks have, for instance, an adequate number of offices in poor areas of a city, where business may not be so profitable as in the rich areas of the city. That is a typical kind of approach. There are rather elaborate rules to make sure that mortgage loans for home purchases are available, to the extent consistent with safety, to the poorest sectors of the society and all races and gender and that there is no discrimination. A quite different kind of concern in the United States is reflected in our rather long-standing rules against combining banking activity with ordinary business; we, by and large with some exceptions, have taken the view that a bank is a bank, or a bank is at least a financial institution, and it should not be directly owned by a business corporation doing ordinary manufacturing or commercial business. Nor should a bank in the United States own an industrial corporation; General Mo-

©International Monetary Fund. Not for Redistribution Paul A. Volcker 49 tors does not own banks and banks do not own General Motors, with some exceptions. So we are in a very complicated area, and my remarks are directed mostly toward that middle area of safety and soundness and prudential requirements, but it is more complicated than that in terms of purposes. As Mr. Erb suggested, the United States has an extremely complicated system for supervision and regulation. I could take the time to describe this system as an object lesson for what you should not do, but I will not do so; instead, I will draw one lesson from the complications of our system, which may be generally valid. Our system is so complicated because it involves very sensitive political and bureaucratic rivalries. The banks do not like to be supervised and regulated; they would prefer that the supervisor in most cases be as weak as possible and have as little influence as possible. There are different types of financial institutions in the United States. They are all concerned about competitive advantages against each other and about maximizing the chance of some competitive advantage. They often want their own supervisor, and they want their supervisor to be friendly to them, so that they strengthen their relative competitive position. All these pressures are brought to bear through the political system and through the U.S. Congress. There have been proposals, over a hundred years, to simplify and strengthen the supervisory system in the United States. Despite all these proposals, the system remains more or less the same. The United States has almost 14,000 banks, and has a long tradition that a bank can be chartered by the states—the individual states—as well as the federal government. We have three or four thousand institutions, called thrift institutions, most of which historically dealt with consumers, but these days they are very much like any other kind of bank. We have tens of thousands of institutions called credit unions, which act somewhat like consumer banks for people in an individual company, or in an individual town, or in an individual association of some sort. All of these institutions may be authorized by the federal government or they may be authorized by a state government. But at the national government level, there are three different agencies supervising banks. If an institution is chartered by a state it has a state supervisory authority as well. There are two different institutions supervising the so-called thrifts. I will not speak of the credit unions, which are smaller. As you see, it is a very complicated, overlapping, confusing situation. Having said all of that, I will make a few personal conclusions, growing out of American experience. They have some relevance to other countries, although particular circumstances differ. My first point

©International Monetary Fund. Not for Redistribution 50 ROLE OF REGULATION AND SUPERVISION OF THE CENTRAL BANKjjjjjjjjjjjjjjjjj is that a strong central bank really needs considerable supervisory authority over the banking system. I say that partly because some of the rules and regulations necessarily flow out of those. But it is also important to a central bank to have a clear sense of the strengths and weaknesses in the financial system when it makes decisions on monetary policy, because those decisions will have different effects on the economy, depending upon the strength of the banks themselves. For instance, if the banking system is in a weak position, it may be difficult to tighten money and raise interest rates without creating more severe disturbances in financial markets. I can tell you that a central bank, at least the American central bank, does not like to be inhibited in the conduct of monetary policy by a sense of weakness in the banks. The best way to assure to its satisfaction that those weaknesses do not exist or are minimized is to have responsibility for supervision itself. Of course, depending upon the country—but true in the United States to some extent—the central bank is entitled to have considerable supervisory authority by the mere fact that it operates very often by lending to those institutions, and if it lends to those institutions, it wants to have some assurance that it can be repaid, and that it is lending to a liquid, solvent institution. The more a central bank operates by lending to banking and other institutions, the more important it is that it has adequate supervisory authority for so-called prudential reasons, as well as for monetary policy reasons. Let me look at the same problem from another direction. I talked about the importance to the central bank, to the strength of the central bank, of having adequate supervisory authority. I think based upon American experience, at least, it is also important to have a strong supervisor if you are going to have effective supervision. There is bound to be a contentious relationship between those that are supervised and those that supervise. If the supervisor is very weak, he will not be effective in enforcing standards of prudence, of safety, and of soundness. Therefore, you need a strong supervisor. In the United States, it is quite clear for a variety of political and other reasons that the central bank is likely to be the stronger supervisor. Its independence and stature makes it the least subject to political and other pressures that supervised institutions bring to bear to weaken supervision. That may not necessarily be true in every country, but I suspect that more often than not the central bank is in the strongest political position, in a sense, to exercise effective supervision. The alternative, at least in the United States, is the ministry of finance. The weakest alternative, again drawing on American experience, is an agency that has no function other than to supervise a particular set

©International Monetary Fund. Not for Redistribution Paul A Volcker 51 of institutions. That was the case in the savings and loan industry in the United States. Savings and loans were the most important so-called thrift institutions and were important competitors of banks. They had their own supervisory arrangements and an independent supervisory authority that, as a practical matter, through the political process, the supervised institutions themselves controlled. They were in effect controlling; that is not what the law said, but that was in fact what hap- pened. Lending by these institutions was historically directed largely toward home purchases. They took most of their deposits and put them in home mortgages. Because that is very popular politically, the U.S. Congress was willing to take a lax view toward these institutions from a supervisory standpoint. It wanted to enhance their ability to attract funds to lend to families so that they could buy a house—a very popular purpose. But through the years, supervision became quite lax in that industry and under the strains of the past decade it is not too strong to say that the industry has largely collapsed. A very large fraction of the industry is bankrupt. Their deposits were insured, so the federal government had to pick up the cost. Estimates of the cost to rescue those depositors over the next few years vary widely, but most range from $250 billion upward—an object lesson in lax supervision. When one looks at the banks and not these thrift institutions, one can see that many of them are subject to more than one regulatory authority, but without going into great detail, the supervision is not perfect by any means. In most cases, the Federal Reserve participates in the supervision, or controls the supervision, but that is not true in all cases. The rivalry between the supervisors themselves sometimes tends to lead to easier supervision than you would otherwise have. That is understood by the supervisors, by the politicians, and by the industry; the argument then is between those that say it is a good idea to have competing supervisory agencies, so that the supervision does not get too tough and is not too detrimental to the ability of the supervised institutions to compete, and those that say we do not want them too weak. There is a constant battle, politically and otherwise, between the desire to make supervision more uniform and more unitary and the desire to keep it more dispersed. The balance goes back and forth over the years, but the system I have described, as you can see, still has a lot of competition between supervisory agencies, which means somewhat lighter supervision than otherwise would be the case. On the other hand, I would argue that in the banking area at least, supervision is rather comprehensive in the United States, and while the system is very messy it does balance two considerations: a strong supervisory authority, which is largely represented by the central bank, and an unwillingness to give too much power and too much authority to any

©International Monetary Fund. Not for Redistribution 52 ROLE OF REGULATION AND SUPERVISION OF THE CENTRAL BANK single supervisory agency, in the interest of permitting a hundred flowers to bloom in the financial area.

MIGUEL MANCERA

ss First, let me tell you that my comments on this topic should not be understood to be applicable to banks only but to financial intermediaries generally. If I do not refer expressly to all of them, it is merely for the sake of simplicity. Bank regulation and supervision play three important roles. The first of these is promoting the soundness of banks to protect depositors. The second is encouraging economic efficiency in financial intermediation. The third is ensuring that banks comply with monetary policy measures and do not circumvent or, even worse, ignore them. As is well known, the average person does not usually have the ability to assess the soundness of a bank. To determine whether or not a bank is healthy requires specialized knowledge and detailed information. This is the reason why most countries have a bank supervisory authority. Whether it is a department of the central bank, of the ministry of finance, or a separate agency, its role is fundamentally the same, that is, to ensure the soundness of the banking system. Laxity with regard to the soundness of banks is extremely dangerous because, among other reasons, insolvency is highly contagious. Poorly managed banks may appear to be successful for a time. In a number of cases, they may show a high rate of growth. This apparent success puts pressure on other banks who do not wish to forfeit their market share to the faster growing banks. Thus, banks will often compete among each other by paying higher interest rates to attract deposits; at the same time, they may relax their lending standards. If this process goes uncorrected, an undesirable situation develops where banks may display one or more of the following negative features: low quality loan portfolios, growing current losses, or negative net worth. These danger signs may go unnoticed for a long time, making correction increasingly difficult to achieve. Poor or irresponsible management is the main reason for bank insolvency. But a bank's unsoundness is also fostered by inappropriate regulations or insufficient bank supervision. For instance, imposing high and inadequately remunerated reserve requirements or forced lending to priority sectors of the economy at below market interest rates may seriously debilitate banks. Also, a legal framework that unduly protects borrowers makes loan recovery difficult. In addition, if banks are not subject to appropriate disclosure rules, problems cannot be tackled in a timely fashion.

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Since bank insolvency may easily become widespread, it can damage the economy for various reasons. (1) If the public perceives banks to be insolvent, depositors will withdraw their funds from banks, inflicting a severe blow to the saving-investment process. Moreover, since banks are major depositories of financial assets, when savers move out of banks, capital flight from the country cannot be ruled out. (2) Resources will be misallocated, as troubled banks often lend to borrowers of dubious solvency as these are usually willing to pay higher interest charges. (3) Since bank deposits will be perceived as risky, interest rates will be subject to upward pressure. (4) If the government sub- sidizes banks to prevent depositors and other bank creditors from losing money, public finances will deteriorate, thereby weakening monetary control. (5) As numerous banks fall into precarious situations, they cannot be expected to be effective vehicles for implementing monetary policy. (6) The widespread existence of bad loans implies a deteriorating economic morality. People may believe that not fulfill- ing credit obligations is socially acceptable, which would hinder economic progress. Under these circumstances, the financial system's development is seriously jeopardized as trust, the most important of its pillars, erodes. For these reasons, bank regulation and supervision should aim primarily at establishing preventive measures, so that "bank diseases" do not arise or, should they appear, be immediately remedied. Foremost among preventive measures is the development and enforcement of good accounting standards. Without them, it is virtually impossible to know where a bank stands; it is also impossible to establish comparisons among banks. Supervisory authorities should determine that the information provided by the accounts is reliable. In this respect, there is a very difficult, albeit crucial, task: to ensure that the information in the loan portfolio provides a fair and truthful report on the quality of the respective assets. Provisions for doubtful loans should be mandatory. The same should apply to write-downs or write-offs of credits that have been partially lost and for those that cannot be recovered. Other preventive measures concern entry into the financial market. In this regard, it is important to keep in mind that meeting the minimum capital requirement to establish a bank should not by itself be enough to obtain a banking license. The human capital, that is to say, the moral and professional quality of the bank's prospective management, is in fact more important than its capital base. No deposit- taking institution should be allowed to be established when the prospective management is not entirely satisfactory to the licensing authorities.

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In recent years, supervisory authorities have devoted much attention—and rightly so—to the capital adequacy of banks. At a certain stage, particularly in some countries, commercial banks became too leveraged. Although it is virtually impossible to establish scien- tifically what the optimum capitalization of a bank should be, it is clear that the higher the leverage, the more vulnerable a bank tends to be. (The recommendations of the Cooke Committee of the Bank for Inter- national Settlements (BIS) reflect a consensus among knowledgeable people on how to judge the capital adequacy of commercial banks.) Concentration of lending is a main source of bank instability. This is the reason most countries have rules to prevent it. Nevertheless, pressure continuously arises for banks to lend disproportionately to a single customer. In some cases, this is because the customer happens to be a shareholder of the bank or a member of its management, or because the customer is somehow related to them. In other instances, concentration may arise because the customer is able to apply political pressure to the bank in question. Since concentration of lending is a common cause of bank failures, supervisory authorities should be especially keen to prevent it. If the supervisory authorities are to be effective, they must be empowered to impose appropriate—even harsh—sanctions for the infringement of regulations. Otherwise, they risk not being taken seriously. When banks become insolvent, or better, when they are on the way to insolvency, supervisory authorities should act as quickly as possible. If they do not, losses usually grow geometrically. Moreover, there is the risk of passing on the insolvency of one bank to others. Remedial action may involve two kinds of measures. One of them is the rehabilitation of the weak bank, and the other is its liquidation. Rehabilitation is generally preferable to liquidation. The latter provokes a general distrust about banking institutions and thus impairs the future development of the financial system. For this reason, liquidation should be seen as a measure of last resort. Rehabilitation may be achieved by various means, such as new shareholder capital appropriations, mergers, or acquisitions. But usually, the key factor in a successful bank rehabilitation is a change or, at least, a strengthening of its management. In fact, except in the rather infrequent cases in which bank failures are attributable to macroeconomic factors or to extremely poor regulation, insolvencies are due to mismanagement. Bank mismanagement not only damages the particular banks involved and the banking system generally but also impairs the efficiency of the overall economy. This is because poor management usually implies that savings channeled to investment through the respective banks are not applied to good projects. This is demon-

©International Monetary Fund. Not for Redistribution Miguel Mancera 55 strated by the preponderance of low quality loans in the portfolios of those institutions. In most countries, central banks play an important role in bank regulation and supervision, but they are not the only regulatory and supervisory authority. It seems to me that the issue of regulations required for the implementation of monetary policy should be a responsibility exclusive to the central bank. Otherwise, the risk arises that competing authorities may distort the objectives of the central bank, jeopardizing the effectiveness of monetary policy. If you recall the distinction between monetary and credit policy that I made in the first session, it seems that there is some scope for other authorities (the ministry of finance, for example) to regulate some aspects of credit operations, such as determining the features of the credits granted by development banks. The best arrangement for the coordination of policy measures, however, may well be that the central bank regulates all or most banking activities. Nevertheless, the ministry of finance or other authorities could have a say in the formulation of central bank policies through their participation in the governing bodies of the bank. Bank supervision may be seen as a different task from that of regulation. The purpose of supervision is to verify that existing regulations are complied with and to impose sanctions when they are not. The supervisory function can be carried out by a department of the central bank. This arrangement has certain advantages. Since the central bank has close contact with the market, it can detect violations more easily than other agencies. Moreover, when someone is in charge of enforcing regulations, he may be in the best position to design them as well. On the other hand, bank supervision may be such a time- consuming responsibility that it could distract the central bank official from crucial monetary policy matters. This may be a good argument for entrusting bank supervision to an agency separate from the central bank. Should this be the case, it is essential that the central bank have a strong presence in the governing bodies of the supervisory agency. Achieving efficiency in the financial system, as in the rest of the economy, is, or should be, a key objective in every country. The question is how best to promote efficiency in the financial system. In my view, the most effective way is through competition. The degree of competition in the financial system does not only depend on the number of banks but also on how able they are to compete with one another and on the number and capabilities of nonbank institutions, which may also form part of the financial system. Moreover, the degree of competition may also depend on the diversity of financial instruments used by the various financial intermediaries.

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The more financial intermediaries encourage the generation of saving and the better they are at allocating such saving to highly productive projects, the more efficient the financial system will be. Ultimate efficiency is attained when financial intermediaries are able to stimulate saving and fund good investment projects while charging narrow spreads between deposit and lending rates and still remain profitable. To encourage saving, the financial system should be able to offer a wide choice of instruments to current or potential clients, so that their particular needs can be adequately met. The same can be said about lending instruments. There should be a variety of them so that the financial support for investment projects can be appropriate to the features of each of them. Finally, a word on the role of profit in the financial system. If profit does not come from monopolistic situations, it should be welcome. Such profit indicates that the respective firm is efficient. It seems to me that aiming at profit in a competitive environment is particularly advis- able in countries where banks belong to the state. In such circumstances, the absence of profit implies the need for budgetary appropriations in order to capitalize banks. This imposes an additional burden on public finances, which are usually already strained. Apart from that, and perhaps of more concern, the absence of profit may be an indicator of an inefficient allocation of resources.

JEAN GODEAUX

aa Regulation and supervision of the banking system or, more ap- propriately, of the financial institutions are a traditional responsibility of banks. For brevity's sake, the words "supervision" and "banks" will be used to describe the exercise of this responsibility and its field of application. Supervision covers two distinct categories of activity. The first is the macroeconomic control that is designed to influence the conditions under which monetary policy can be made effective, or more effective: such as the power to impose reserve requirements on various ratios. Quite naturally this power should be vested in the central bank, and it is so vested in most countries. The second is the ensuring and monitoring of the soundness of financial institutions and the financial system. Obviously, these two supervisory activities are interconnected, even complementary. I shall hereafter speak mostly of the second, generally called prudential control. My considered opinion, and that of all central bankers, is that prudential control is more necessary than ever. On account of the inter-

©International Monetary Fund. Not for Redistribution Jean Godeaux 57 nationalization of capital markets, on account of the spread of financial innovations, and on account of a general movement of deregulation of financial markets, one has to accept the view that the risk of unstable international financial markets has increased, and there exists now, more than in the past, what may be called systemic risk, namely, that the whole system itself might be endangered by a difficulty encountered by one institution in one country. Now, as regards the way in which this prudential control is being exercised, there are basically in Europe two ways at the institutional level. One is to have this prudential control vested in the central bank; as everybody knows that is the case with the Bank of England, the Bank of Italy, the Bank of Spain, and the Bank of the Netherlands. The other is to have prudential control vested in a separate institution; that is the case in the Federal Republic of Germany and in my country, where prudential control is entrusted to the banking commission. France is a special case. There is a separate institution, but this institution is run by the Bank of France, so that in practice the supervisory activities as regards prudential control are exercised in effect by the Bank of France. Whatever the institutional setup, there must be, as Mr. Mancera pointed out, a close involvement of the central bank in prudential supervision. Whenever there is a separate institution, there must be a strong presence of the central bank in that institution or, at least, a close liaison. In my country, for instance, a banking commission was created in 1935 (the central bank had been created in 1850). Two of the six members of the commission are appointed from a list of candidates proposed by the central bank. And one of the appointees has, by tradition, always been a member of the board of the central bank, often the deputy governor. I may pass briefly over the methods by which this prudential control is exercised. As in most countries, it is a combination of the monthly transmission of detailed statements, on-the-spot examinations, either occasional or continuous, and—what is feasible in a small country with few institutions—regular contacts of the supervisory authority with top management. A short historical account of the evolution of concepts, preoccupations, and methods at the international level may be more interesting. The first, and probably most important, episode in this history was the creation of the bank supervisors' committee in Basle, in the framework of the Group of Ten (G-10) countries. This committee was chaired orig- inally by Mr. Blundon and then by Mr. Cooke, both of the Bank of England, and now by Mr. Muller of the Netherlands Bank. The committee of bank supervisors was called into existence by the G-10 Governors in the wake of the first large "bank accident," the Herstatt affair, as

©International Monetary Fund. Not for Redistribution 58 ROLE OF REGULATION AND SUPERVISION OF THE CENTRNKhhhhhh some of you may remember. The first result of their activities was the conclusion of an agreement, the so-called Basle Concordat. It was designed to make sure that no banking institution in the G-10 countries and progressively in a wider circle would escape supervision. The Basle Concordat established the principle of "home country control," namely, that the supervising authorities in the country of the parent company would be responsible for control over all subsidiaries and branches of the bank, whatever their location. A second moment in this history of international cooperation on prudential control was the creation, again by G-10 Governors, of a special working party, chaired by Mr. Cross, First Vice President of the Federal Reserve Bank of New York. This working party was commis- sioned to write a report on financial innovations in international banking and their consequences on prudential control. The Sam Cross report was for a time a "best seller," except that it was not sold but freely distributed by the BIS. It was almost required reading for every banker. An updated version would probably be very useful but would require a great deal of work. A third step was the conclusion, in 1988, if I am not mistaken, again at the G-10 level, of an agreement on minimum rules with regard to capital adequacy. But the most important development, in my view, occurred in the EEC. For a long time the method of European unification was "harmonization" of rules and regulations and administrative practices. This attempt at complete harmonization led to lengthy procedures, "som- ber" procedures as Jacques Delors once called them, and consequently to intolerable delays. On the proposal of the European Commission and in the framework of the European Act—the first important amendment to the Treaty of Rome—the tiresome attempt at complete harmonization was replaced by the acceptance of two principles: "mutual recognition" and "minimum harmonization." Once a minimum level of "commonality" of regulation or administrative practice had been reached, countries of the EEC would accept that their respective rules would be sufficient. In the field of banking control it would mean, for instance, that a license to operate a bank in any one country of the Community would be valid in all other countries of the Community. By this method we could speed up the attainment of two factors that we consider essential for achieving "the great integrated market": freedom of establishment of financial institutions and freedom of provision of financial services. Against this background of mutual recognition and minimum harmonization, the authors of the Delors Report considered unanimously that the mandate and functions of the future European System of Cen-

©International Monetary Fund. Not for Redistribution Summary of Discussion 59 tral Banks should comprise the four following elements: (1) It would be committed to the objective of price stability; (2) it should support, subject to the foregoing, the general economic policy set at the Com- munity level by the competent bodies; (3) it would be responsible for the formulation and implementation of monetary policy, exchange rate and reserve management, and the maintenance of a properly functioning payment system; and, (4) it would participate in the coordination of banking supervision policies of the supervisory authorities. We see thus that responsibility for a "properly functioning payment system" and "participation" in the coordination of supervision policies are viewed by all as essential elements of the functions of central banks. This leads me to answer with a clear yes the question: Is it necessary that the central bank should have an important authority in the field of prudential control of financial institutions?

SUMMARY OF DISCUSSION

RICHARD D. ERB Let me take a few moments to comment on some of the main points that were made during the course of this morning's discussion. First, during the discussion of the purposes of supervision and regulation, there was strong consensus on the importance of regulation and supervision for monetary control and for the safety and soundness of the banking system. Mr. Volcker indicated that there may also be social concerns that require supervision and regulation. Mr. Mancera talked about the need to encourage efficiency in financial intermediation; this was perhaps related to what Mr. Tong was saying when he indicated that the central bank should promote development of financial intermediation. Mr. Godeaux introduced the international dimension with respect to the purposes of supervision and regulation. As Mr. Volcker said, this may not be of immediate concern to China but certainly within the near future it will have special relevance, as the economy opens up further. Then there was discussion of the question of who should supervise and regulate. As each speaker indicated, practices differ across countries and have also differed over time. One conclusion that we can draw from this is that the issue of supervision and regulation is dynamic and must always be kept under review and examination to be sure it is keeping up with the times. There was strong consensus, not sur- prisingly, that the central bank should play a key role in supervision and regulation, or, at a minimum, the central bank should have responsibility for the regulation and supervision that is key to the implementation of monetary policy.

To the extent that there are separate supervisory agencies, the central bank should have a strong presence. But the point was also made that whoever supervises should be strong and also independent, independent of political pressure and independent of the institutions being supervised. Mr. Mancera indicated that it was implicit in the statements of the other speakers that the broader environment has an impact on the scope and effectiveness of supervision. For example, the legal system: to what extent does it protect—overprotect—borrowers. There may also exist political pressure and laws that require forced lending to priority sectors at low, market interest rates. Accounting practices and standards may also influence the safety and soundness of banks. Then there is the more general question of changes in the financial markets that may come about in the course of financial deregulation. Mr. Godeaux mentioned that these changes could be technological changes in communications, and computers, etc. Mr. Volcker, when talking about the changes in international banking, commented that there will be growing economic and financial integration across countries. Beyond that, the experience exists in many countries that enterprises are often very imaginative in finding ways of responding to limitations. It is often hard to stop innovation. Mr. Mancera had said in his statement that poorly managed banks may appear very successful for a time, and when a dangerous situation goes on for a period of time corrections are difficult to achieve. Negative systemic consequences, he indicated, can occur if there is widespread insolvency. I think that is a pattern in many countries: when problems arise in an individual bank, or even across a number of banks, everyone is often caught by surprise. This leads to the question of the usefulness of preventive measures, good accounting standards, for example, provisions for bad loans, adequate capital standards, minimum entry standards; these are ways of providing some protection, some preventive assistance.

CHEN YUAN a 1 am delighted to have this opportunity to speak about the internal structure of the central bank. Before 1979, there was only one bank in the People's Republic of China, namely the People's Bank of China. It was then both an issuing bank and a bank handling credit business. Such a banking system, despite having made undeniable contributions to the development of the national economy, has barricaded effective allocation of funds and become obsolete with the development of a commodity economy. Since 1979 when the economic reform was launched, the commodity economy has developed rapidly. This has created the need for an institution exercising financial control and management with authority, power, effectiveness, and the ability to make overall plans taking all factors into consideration. The institution should also have adequate economic and administrative means to secure effective control and management. Such an institution is the central bank. In September 1983, a decision made by the Chinese Government enabled the Peo- ple's Bank of China to function solely as the central bank—the beginning of a central bank system. The People's Bank of China is a state organ that exercises, on behalf of the State Council, leadership and control over the financial sector with overall responsibility in (1) formulating principles and policies that guide financial activities, submitting them to the State Council, and organizing the implementation upon approval by the State Coun- cil; (2) drafting financial laws and regulations; (3) providing rules and regulations for operation of the financial sector; (4) controlling the issuance of money, regulating the circulation of money, and stabilizing the currency; (5) controlling interest rates on deposits and loans and fixing the exchange rate of renminbi against foreign currencies; (6) formulating the state credit plan and exercising centralized management of credit funds and working capital of state enterprises; (7) imposing foreign exchange control, the control of gold and silver and of

©International Monetary Fund. Not for Redistribution 62 STRUCTURE OF THE CENTRAL BANKgggggg official foreign exchange reserves and gold reserves; (8) examining and approving the establishment, elimination, and merger of banks and other financial institutions; (9) providing leadership, regulation, coordination, supervision, and audits for business activities of specialized banks; (10) managing the state treasury and acting as an agent for issuing government securities; (11) regulating the issuance and trading of securities, such as stocks and bonds of enterprises, as well as regulating the financing market; and (12) engaging in international financial activities on behalf of the government. The highest authority of central banks around the world is classi- fied into three categories. First, the power for decision making and for execution is vested in one body, as in the Federal Reserve system of the United States and the Bank of England. Second, the highest authority is divided into a decision-making body and an executive body, as in the Bank of Japan, the Deutsche Bundesbank, and the Bank of Italy. Third, the highest authority is divided into a decision-making body, an executive body, and a supervisory body, as in the Bank of France, the National Bank of Belgium, and the National Bank of Switzerland. The highest authority of China's central bank falls into the first category. The Council of the People's Bank of China has acted only as an advisor in recent years. As in many central banks, the governor plays a crucial role; however, as the People's Bank is under the direct jurisdic- tion of the State Council with the governor appointed by the Premier, final decisions of monetary policy hinge to a large degree on the State Council. In terms of decision making within the central bank itself, the following three factors are crucial and decisive to ensure that decisions made are scientific and suit reality. First, the ability to capture and collect, through various channels, information and data on macroeconomic performance and to keep abreast of the latest developments in the economy; second, economists who are highly qualified and well aware of the real economic conditions and are thus able to make correct judgments and come up with creative policy recommendations; and third, the smooth flow of economic information and policy recommendations to the highest decision-making body of the central bank. We are of the view that within the central bank, information, planning, operation, and supervision, which are at the second level next to the decision-making level and are interactive, constitute the internal operating mechanism of the central bank. Such a mechanism translates policies into actions to influence macroeconomic activities on the one hand, and provides, on the other, feedback for the decision-making body so that policies can be duly revised and supplemented. Within the People's Bank, there has been a lack of satisfactory coordination among areas such as the regulation and supervision of

©International Monetary Fund. Not for Redistribution Chen Yuan 63 financial institutions, the management of central bank resources, financial programming, and the formulation of long- and short-term credit plans, as well as the survey, research, and monitoring of economic performance, which in turn has crippled the decision making of the bank. In this sense, it is crucial for the governor of the central bank to make correct decisions on the division and coordination of internal operations. Regional branches of the People's Bank are set up in line with administrative division. Such a structure has had both positive and negative effects on the implementation of monetary policy. What lies at the core of the problem here is the allocation of central bank funds, namely, how much of the funds should be placed at the disposal of the head office and its regional branches, respectively. Expe- rience has shown that a certain degree of centralization of power is still necessary under current conditions. Such powers include imposing mandatory plans on the allocation of funds within the central bank system, examining and approving the establishment of relatively large nonbank financial institutions, and establishing the level of interest rate and its floating range. The current trend has indicated that regional branches are mainly responsible for the implementation of orders issued by the head office, for the execution of the credit plan of the region and for organizing finance, and for the regulation of banks and financial institutions in the region. As regional branches have been established in parallel with the setup of administrative division, some of them have frequently experienced administrative intervention of local governments, which has always been translated into pressure on the head office. This has been for a long time a headache for the head office. Despite the fact that the system of the People's Bank is vertical, regional branches have maintained close ties with local governments because of mutual interests. We have thus been caught in the dilemma that although we hope to reduce administrative intervention of local governments, we have had to rely on them to organize the implementation of monetary policy and the realization of the macro control target. Solutions have been explored and will continue to be researched in the course of the reform. We are very interested in learning the relationship between the Federal Reserve Board and the twelve Federal Reserve banks in terms of allocation of funds, distribution of power, personnel management, and cost-profit sharing. We also hope to study, together with our American counterparts, what will be the effects of relative independence of regional branches on monetary policy.

Given the sophistication of modern economic development, central banks around the world are becoming increasingly concerned about the analysis and study of information. Formulation of correct monetary policy and effective implementation require a department for information analysis and research that responds quickly, captures various kinds of information, and makes comprehensive and accurate judgments. Great progress has been made in this area in the People's Bank of China in recent years; however, our research department still lags behind its counterparts in Western central banks with regard to the scope and speed of information, ability of comprehensive analysis, and quality of the research team. Within the People's Bank, three departments are engaged in research: the Department of Research and Statistics, the Office of Policy Research, and the Research Institute of Finance and Banking. The three are responsible for different areas of research: long-term research, information analysis, theoretical research, and strategic research. Their work is to describe monetary developments, to study the relationship between money and macroeconomy, to study changes in the government budget, prices, output, investment, and the balance of payments, and to provide analysis, judgments, and policy recommendations as refer- ences for the decision-making body of the bank.

PAUL A. VOhR

aaaa When things are going smoothly, I think what Miguel Mancera said this morning is quite true, the central bank is not very prominent, it does not appear to have terribly difficult decisions to make, because the necessary adjustments are not very large. Most people will not know what the central bank is when things are going smoothly. It is only when things go poorly that the central bank becomes prominent. I think I made the main points that I wanted to make in this area the other day, when I spoke of the importance of a central bank having an adequate status, adequate prestige within the whole governmental apparatus. If it is going to be able to take the kind of decisions, the kind of difficult decisions that it is occasionally forced to take, and have those decisions respected not only by the rest of the government but also by the public at large—and that is a larger concept in the precise legal status of the central bank—it helps to have a strong degree of legal independence; specifically, that it does not simply report, let us say, to the finance minister, or some other minister, which is the pattern followed in some countries. The tendency these days has been moving in the other direction, to provide more independence, which, I think is a reflection of the recognition of severe inflationary problems around the

©International Monetary Fund. Not for Redistribution Paul A. Volcker 65 world and the idea that the central bank has to be given more authority to deal with them. The most striking illustration of that is what goes on in Europe in connection with the discussion of European monetary unity and what characteristics a central bank should have in that connection. But I will let Governor Godeaux speak on that. Most central banks in that connection, I might say are self- financed. The easiest, I do not know about in socialist countries, but the easiest and most assured way to make money in a capitalist country is to control the printing press. When you create money, which has no interest, you can acquire assets with the money you create; it is a sure way to make money. Most central banks are authorized to keep a small fraction of the money they make to finance themselves and that itself provides a certain degree of independence and authority. I understand that this is not the case in China, but I recommend that the situation in China be reviewed. Otherwise, you are not consistent with the practice in almost all the rest of the world. But, more fundamentally, the status and prestige of the central bank will lie with public attitudes, with the strength of the people running the bank and how independent they are, and how much they are willing to fight for what they think is important in terms of stability, or whatever. But this is nothing, as these remarks suggest, that comes automatically; if you are going to have influence, or if you are going to have real autonomy and real independence of judgment, you have to earn it. You earn it in part by the importance, for instance, of the research function, the channels of information, and the professionalism of the staff, as the Vice-Governor of the People's Bank remarked. That seems to me absolutely essential and it has to be built up over many years. I think it is typical, certainly of the Federal Reserve, but typical of most central banks, in most countries, to give a lot of attention to the research function, a lot of attention to having the best possible economists on the staff, and lawyers and others, insofar as those professions are important. A lot of attention is given to training, a lot of attention is given to continuity. That is quite characteristic of most central banks, and it has always appeared to me, from the standpoint of a developing country, that the Bank of Mexico has had particularly interesting and important experience in that connection. Let me say too, perhaps because it strikes me out of American experience recently where we have had quite a few scandals in government and quite a few accusations of political influence, that a central bank that deals with money, by its nature, and deals with very difficult financial decisions, to be effective, really has to be beyond suspicion, in terms of its basic financial character and in terms of its absence of any sense of financial or other corruption. By and large, central banks

©International Monetary Fund. Not for Redistribution 66 STRUCTURE OF THE CENTRAL BA around the world have had a good record in that respect, and if they do not have a good record, it will be very destructive of what they are trying to do in terms of policy. I think by the nature of their responsibilities, a bad record will be even more destructive than for other government agencies that are accused of corruption or the lack of good financial controls. A third related point is that it helps when, at least again in the American context and contrasted with some other government agencies, the personnel and the senior personnel are by and large career oriented; they are not people who are there temporarily—in this year and out the next. They are not people who are appointed essentially for political or partisan reasons, or for ideological reasons; they are there professionally. In the Federal Reserve, the top governing body is the Board of Governors—seven people. They are appointed as part of the political process; they are appointed by the President and must be approved by a majority of the Senate; that is the way all senior government officials are appointed, and in that respect the Federal Reserve is no different. But it is different in two respects. By and large, the tradition is that the people appointed to the board are not highly partisan; they are not political and very seldom do they have a political background. They typically have a professional background. The terms are very long, fourteen years as a member of the Board of Governors; the chairman has a shorter term—maybe that is appropriate too—but the basic board terms are very long to provide an element of independence in a nonpolitical orientation. People on the Federal Reserve Board are not looking for a political office; they are typically not looking for another job; that is their job, and that is what they have been professionally interested in. It is not at all unusual for a career staff person to be appointed to the Board of Governors; that is unusual in other departments. Very seldom does the head of a department, or the undersecretary, or the vice-minister come up through the ranks. But in the Federal Reserve that is not particularly unusual. Except for the Board of Governors, the staff is almost entirely career oriented and nonpolitical. The same holds true for the presidents of the various Federal Re- serve banks. They are not always career people. In fact about half of them are career people; half of them have been appointed from outside, but they are not appointed by the President, nor are they appointed by part of the political process. They are nonpolitical people; they are professional people. So all of that has helped contribute to independence in fact, whatever the law says, and the law in the United States does provide for independence for the Federal Reserve, meaning independence from the President; it is the U.S. Congress that passed the law,

©International Monetary Fund. Not for Redistribution Paul A. Volcker 67 and Congress can always change the law. But they would have to go through the process of changing the law. What the law provides is that, unlike other government departments, the Federal Reserve does not report to the President of the United States. It does not mean that the department, the agency, or the chairman, in particular, does not maintain communication with the President. It does not mean that it does not maintain very frequent communication with the Secretary of the Treasury. It means that neither the President nor the minister of finance can order the Federal Reserve to do anything. You can discuss problems, and that discussion can go both ways. Perhaps the relationship of the Federal Reserve to the finance ministry is symbolized by something that has become a custom over many years. There is typically at least one meeting a week between the Secre- tary of the Treasury and the Chairman of the Federal Reserve, at lunch, and they may meet much more frequently than that, but they do try to meet once a week at least. Even when there is no special problem, that meeting on alternate weeks takes place at the Federal Reserve and at the finance ministry, so that there is no sense that one agency or the other is responsible to the other one. We maintain a formal quality in where the meeting takes place. Let me just conclude by saying a few words about the regional organization of the Federal Reserve, since that request was made specifically. I suppose we have certain resemblances to China in the sense that we are both large countries, with a population spread over a vast area, and indeed, I think with centers of influence in the country spread over a vast area. Perhaps I can talk with a reasonably dispassionate view on this subject, because I once worked for the Federal Reserve Bank in New York, and I was chairman of the Board of Governors, so I have seen the Washington perspective and the regional perspective firsthand. From either perspective, as I am sure you know in China, the relationship is not always perfectly smooth and harmonious. Between the regions and the central office, there is bound to be some tension in that relationship and indeed to some degree that tension is deliberate. I must say that in practice the relationship has changed quite a lot over the years. As I indicated the other day, when the Federal Reserve system was established seventy-five years ago, there was some idea that monetary policy, at least, might be modified a little bit to suit the needs of different regions of the country. That idea did not last very long and it is virtually impossible to think about now in terms of the speed and ease of communication and financial flows through the country. As a practical matter it is impossible to have different monetary policies in different parts of the country. And through the years, literally decades, a considerable effort was made, with the emphasis naturally coming from

Washington, to make as sure as the central authorities could that monetary and supervisory policy was administered uniformly through the twelve Federal Reserve districts. At the same time, the more purely administrative function has been pretty well decentralized. The various Federal Reserve banks hire and fire and train their own people; they each have their own research department. While there is some interaction with Washington, those operations tend to work quite independently. Washington exerts some general control over salary levels, but these days does not set individual salaries for the senior officials in the region; they have their own Board of Directors, comprised of local businessmen, and no salaries or other employment conditions are set, subject, of course, to some general restraint in the local areas rather than in Washington. I would point out two things. First, even in administrative matters, the reserve banks are a good deal less autonomous than they were ten years, twenty years, or thirty years ago, for purely technological reasons. The Federal Reserve system as a whole, and the regional Federal Reserve banks, carry out certain more or less mechanical functions: they issue currency, they clear checks, they run the system for sending money electronically through the country. Those functions, except for the electronic function, used to be done more or less by hand. It was not necessary to have precise operational uniformity around the country. These functions are now all done by computer, including counting the currency. Even those computers are very sophisticated and have to be uniform throughout different districts. When you are sending funds around the country electronically, the electronic systems have to be able to interact with each other. When a bank in New York gives an order to send money to a bank in California, or vice versa, they have to know exactly how to do that, the way the order is specified, the way it will be received. Those systems basically have to be identical, in both banks. These are big, important functions, so that banks are forced into more and more uniformity between them and that brings less opportunity for administrative experimentation or administrative differences. I would also point out that the Federal Reserve regions do not conform with political subdivisions. In the State of New York, there is a Federal Reserve bank in New York City, but it does not quite conform with the State of New York, although it almost does in that case. But most Federal Reserve banks cover a lot of states, five states, ten states; so there are no political regional officials that feel either a sense of responsibility to the local Federal Reserve bank or particularly oppressed by the local Federal Reserve bank; they are only one of many.

There has never been a lot of interaction at the local level with the local political authorities. There are some meetings, some contact from time to time, but it is practically unknown for local political authorities to try to exert influence on the regional Federal Reserve banks, and that may be a somewhat different situation than in China. The question that is asked from time to time is that if we were starting anew, not in 1913, but if we were starting today, would we have this, administratively, very cumbersome system of twelve different Federal Reserve banks. The answer to that is almost certainly no. You would not think of doing it in today's nation where transportation and communication are so quick and cheap. You would not think of setting up so many banks—you might have regional offices—but they would not have the same amount of autonomy that the Federal Reserve banks were intended to have. But if you ask the question somewhat differently, does it make sense to have some regional offices, maybe not twelve, but maybe four or five, would that still make sense? My answer would be a strong yes, because it does help to bring some perspective to the councils of the Federal Reserve system that are a little different than what you have in Washington. But if that is going to be effective and they are really going to be useful, some authority must be given to the regional authorities, and that is done in the Federal Reserve system, because the presidents of the twelve Federal Reserve banks come together and meet with the seven members of the Board of Governors in Washington. This group of nineteen is the main policy-making body of the system so far as monetary policy is concerned. A body called the Federal Open Market Committee controls open market operations; open market operations are the most important instrument of policy. Months will go by when that is the only instrument used, sometimes years. So the presidents serve as equals on the open market committee, and it is that which makes that position a really important office. It gives influence in the overall policy-making to some sense of what is going on in the rest of the country. Only half the presidents can vote; they rotate, but they all meet together and discuss together. Sometimes, the size of the group is a little cumbersome, but it is a way of maintaining a wide representation, and a balanced thoughtful view as to what policy should be. I would suggest to you, the more independent the central bank, the more autonomous the central bank, the more necessary it is to have the policy-making body a representative board, rather than a single person—at least in the context of the United States; I do not know about other countries. But if the Federal Reserve has as much authority as it has, to give all that authority basically to one person would not work. It would make

©International Monetary Fund. Not for Redistribution 70 STRUCTURE OF THE CENTRKhhhhh the organization very vulnerable. You want the protection, so to speak, of a governing body rather than a governing person, and when you read about the Federal Reserve I know it often does not appear that way; it is always personalized, the chairman gets all the attention. You would think the chairman is making all the decisions. It is fair to say that the chairman has more influence than any other single member, but it is a board making the decisions, and for a large country with a quite independent central bank, there is something to be said for that approach. In that context, I continue to think that the regional structure, which has some roots in and participation with the local business community, continues to be a source of strength, even though it is rather cumbersome and even though in the end monetary policy has to be controlled centrally and be uniform throughout the country.

MIGUEL MANCERA When asjkjjj strong central bank, one can go further and ask whether there is a need for a central bank at all. In countries—nonexistent today—that had only a commodity currency, there was no need for a central bank. In the case of a metallic standard, for instance, an officially recognized mint would be enough to transform gold, silver, or whatever into legal tender. In another case, that of countries which use a foreign currency as legal tender, there would be no need for an issuing bank either. Except in very special situations, countries have found domestic fiduciary money—the so-called fiat money—to be preferable as legal tender to commodity currencies or foreign currencies. The main reason for this is the large social cost implicit in the acquisition of the respective commodity or foreign exchange. Yet even if fiduciary money is to be used, the need for a central bank is not yet compelling. After all, money could be issued by the ministry of finance or by some other government department, in the same fashion as coins are still issued in many countries, albeit in many cases under the directives of the central bank. Paper money could also be issued by commercial banks as, indeed, was the case in many countries, over long periods. Paper money is generally issued by central banks for historical reasons. The extended use of paper money was developed in many countries by one or more commercial banks, which over time were permitted to issue substantial amounts of bank notes. However, as the issue of legal tender and the seigniorage associated with it have been widely recognized as a privilege of the state, central banks began to develop, to

©International Monetary Fund. Not for Redistribution Miguel Mancera 71 the point that today, perhaps in all countries using domestic fiduciary money, they are the sole institutions empowered to issue bank notes. Since central banks evolved from the model of commercial banks, the former also conduct some basic banking operations, such as deposit taking and foreign exchange dealing. They also perform two other nor- mal banking operations—lending and investing in securities—which for central banks are of the utmost importance. It is mainly through lending and investing in securities, as well as by means of foreign exchange dealings, that "base money" is created or destroyed. Let us recall that base money is usually understood to include not only bank notes and coins but also sight deposits in the central bank, which are mainly those of other banks. In previous sessions, we discussed the role of central banks in promoting price stability and balance of payments equilibrium. The achievement of both objectives depends to a large extent on the evolution of the monetary base and on how money is created or destroyed. A too rapid monetary expansion will eventually produce inflationary pressure, and this expansion is bound to occur if the government (or other entities) indulges excessively in borrowing from the central bank. It is by no means a foregone conclusion that when the central bank is under the control of the government the latter will irresponsibly rely on the financing of the former. There are historical experiences that prove the opposite. In my own country, where the central bank is not independent, there have been long periods when fiscal policy has been carefully conducted and reliance on central bank credit has not been excessive. On the other hand, even if a central bank is independent, monetary stability is not guaranteed. The central bank could opt, by its own decision, for an expansionary policy. History also records some examples of this. Nevertheless, historical and international experience demonstrates a well-established and positive correlation between the independence of the central bank and price stability. What is the explanation for this correlation? There is not an easy answer. One explanation that I find convincing, however, is that politicians are subjected to many pressures to spend liberally, which they simply cannot often resist, even though in many cases they are fully aware of the consequences of excessive spending. This inability to exercise the necessary restraint seems to be a justification for an independent central bank. On the other hand, it may happen that as the government spends liberally and the central bank does not accommodate the borrowing requirements of the public sector, interest rates increase, perhaps to very high levels. As a result, the private sector is crowded out of the

©International Monetary Fund. Not for Redistribution 72 STRUCTURE OF THE CENTRAL BANK financial markets. In that case, the central bank may come under significant pressure from actual and potential credit users, foremost among them the government itself, to expand credit in order to lower interest rates. It takes a strong and courageous central bank to be able to resist the joint pressure of the government and the private sector, which will most likely include, among other unpleasant elements, harsh criticism in the media. Since both politicians and central bankers may be subjected to strong political pressure to adopt an expansionary policy, why are central bankers usually more reluctant than politicians to yield? In spite of my being a central banker, I would not dare to say that it is because we are more sensible or virtuous men. That would be nonsense. The difference stems from other reasons. One is that central banks are usually—albeit in many instances unfairly—held responsible for the stability of the currency, either legally or politically; whereas they are not held, at least directly, responsible for the construction of public works, for subsidizing certain prices, or for other actions involving expenditure. Therefore, central bankers, out of enlightened views or simply because of self-protection, tend to adopt and implement policies consistent with price stability. A second reason for central bankers' concern with price stability is that in the case of independent central banks, the term of tenure for the members of the governing body is fairly long, and, more important, it does not coincide with the term of office of politicians. This gives central bankers a longer-term responsibility and concern over the consequences of monetary mismanagement. Still another reason why central bankers are often more prudent than politicians in monetary matters is that, because of either legal provisions or of tradition, the former are chosen from among people with at least some alleged, if not always real, understanding of the influence of monetary policy on the economy. It appears then that in order to enhance the prospects for monetary stability, central banks should be independent from their governments. Central bank independence requires at least two elements. First, that the central bank cannot be forced to lend or to buy securities to any extent beyond what its governing body deems appropriate, and second, that the members of that body cannot be removed before their term expires and that such term does not coincide with that of the government. To ensure the noncoincidence of terms, the members of the governing body of the bank should be appointed one at a time, at fixed intervals, as in the United States and some other countries. Monetary policy is so important that it is unthinkable that it should be left in the hands of one person. This is why most central

©International Monetary Fund. Not for Redistribution Miguel Mancera 73 banks have a board plus, in some cases, committees or other formal groups of persons that decide monetary policy. These bodies, which for the sake of simplicity I will call "the board," will not have much practical significance if the central bank lacks the power to deny credit to the government. Should that power not exist, then monetary policy is, in fact, not decided in the central bank but elsewhere. When monetary policy is decided in the central bank, there is still the possibility that its board is dominated by officials of the ministry of finance or of other ministries or government departments. Although this situation does not make for an independent central bank, it is to be preferred to the one described above, since the voice of the central bank officials will probably have greater weight. A somewhat better arrangement would be for the members of the board not to be government officials, even if they are appointed and can be freely removed by the government. In this scheme, the central bank is not yet fully independent, but at least it becomes a peer of the ministries and its strength is thereby considerably increased. The best formula I have found so far is that the members of the board be replaced or reappointed, one by one, at fixed intervals—these being long enough to make it very unlikely that a given administration would be able to appoint a majority of those members. There should also be legal provisions intended to ensure that, to the largest possible extent, the members of the board are selected only from persons with the best qualifications. On the subject of nonindependent central banks, it must be said that in some instances they may be quite strong in spite of their statu- tory limitations. They can be strong when they command a great ability to persuade, not only within government circles but also among public opinion leaders. The influence and persuasiveness of a central bank will rest on the quality of its research work, on its experience, and on its ability to communicate. I shall deal later with the role of economic research in a central bank and with the task of explaining monetary policy. For the moment, let me say a word about experience in central banks. It obviously derives from the permanency of the staff and from the stability of the membership of the board. I do not know of a prestigious central bank where both these conditions are not met. Another source of power for a formally nonindependent central bank is the prestige of the staff itself and particularly of the governor and of the other members of the board. When a governor is highly regarded, the mere possibility of his resignation as a result of a policy disagreement may well deter the government from proceeding with the policy in question. Government officials would have to ponder the cost of the financial crisis that might ensue from that event. The prestige of

©International Monetary Fund. Not for Redistribution 74 STRUCTURE OF THE CENTRAL BKhhh the staff, of the governor, and of the board is also essential in another sense. A crucial element for the good functioning of the economy is confidence in the authorities. Therefore, if the monetary authorities are able to command the confidence and the respect of the government, of the financial markets, and of the population at large, as well as that of the international community, the chances for the good functioning of the economy are greatly increased. The question arises here as to how best to promote the high quality and permanency of the staff. In this respect, the experience of the Bank of Mexico may be interesting since our staff, it seems to me, is generally well regarded. The reasons for that quality are mainly the following. (1) We try to recruit only the best people. The candidates have to pass several tests. Logically, the nature of some of those tests varies in accordance with the job to be performed. (2) We offer many training opportunities to our employees, whether they be waiters, clerks, secretaries, professionals, or officials. The most promising young professionals are offered scholarships to the best foreign universities. (3) Prospects for promotion are enhanced by the tradition of not hiring people from outside the bank except to fill vacancies at the lower ranks of each branch of service. (4) Open discussion of the problems to be tackled by the central bank is strongly encouraged. This makes many people feel that they are participating in policy-making; at the same time they contribute very good ideas. (5) Salaries enable the staff to live reasonably well. Salaries of high-ranking professionals and officials are, in quite a few cases, below market levels considering the qualifications of the persons involved: this is compensated for by pensions that are rather generous. Coming back to the topic of central bank independence, it must be said that even if it is in fact independent, consultation between the central bank and the ministry of finance and other authorities should still be extensive. Obviously, central banks do not operate in a vacuum. Therefore, the action of a central bank will be the more effective the better it is coordinated with the government's policies in the fields of public finance, domestic and foreign trade, industry, employment, etc. The issue concerning central bank independence that I find perhaps the most difficult to address is accountability. In a democratic society, independence cannot mean unaccountability; yet how to make the central bank independent and yet accountable is not an easy matter. Some formulas have been suggested for this purpose. One is that monetary targets be established (some suggest that they should be set by law) and that the central bank board be held responsible for com- pliance. This is not a new scheme. In fact, the Bank of Mexico Organic

Law had a provision of that type in the late 1930s. Unfortunately, it was never enforced and was eventually removed. Undoubtedly, there is considerable difficulty in adopting monetary targets that are not highly debatable. This is why some of the most respected central banks have changed the nature of their monetary targets over time, even in recent years. At any rate, some sort of monetary targeting should be tried, and the central bank should preserve the possibility of modifying the objectives should they prove unsuitable for fostering orderly economic conditions. The new Organic Law of the Bank of Mexico, in force since 1985, provides for establishing an annual ceiling on domestic credit, although a certain notorious loophole that makes the provision ineffective is still present. What is generally agreed upon is that a way to make the central bank accountable is to require that its policies and their implementation be explained extensively to the public. For this purpose, the central bank and its officials should communicate through reports, articles, speeches, panel interventions, private meetings, etc. Presentations to parliamentary committees may also be included; whether all these measures satisfy the accountability requirement in a democratic society is a matter for debate. With regard to the role of the research department of the central bank, I can hardly find something to add to what has been expressed in the background paper provided by the IMF. Finally, in reference to the role of the branches of a central bank I would like to say that they can be most useful as currency distribution centers, as providers of clearing services, as gatherers and preliminary analyzers of data and information, generally, and as vehicles for the central bank to communicate with the local communities. Neverthe- less, I believe, they should be absolutely forbidden from deciding on fundamental questions related to credit operations or foreign exchange dealings.

JEAN GODEAUX 1 am in complete agrjjjjtions expressed by Mr. Volcker and by Mr. Mancera. I shall therefore not attempt to repeat what they have excellently said. I shall simply bring into the debate some illustrations taken from the history, both distant and contempo- rary, of my former central bank, and more generally, of central banks in Europe. In Europe—apart from the Bank of Sweden and the Bank of En- gland, which were created in the seventeenth century—the central

©International Monetary Fund. Not for Redistribution 76 STRUCTURE OF THE CENTRAL BANK banks were created throughout the nineteenth century, from the beginning (the Banque de France) to the last quarter of the century (the Reichsbank). Basically, their legal form and their institutional setup reflect the circumstances and the preoccupations of the period, despite successive, sometimes important, amendments. Each of these central banks did, at one time, exercise the functions of a commercial bank. Their statutes still contain elements reminiscent of the commercial company that they once were. They are the product of custom, tradition, and of a prudent incorporation of elements of "modernity." The important exception is the Deutsche Bundesbank, the only central bank with "modern" statutes. It is, no doubt, the distant heir to the Reichsbank, but its basic legislation originates in the Bank Deut- scher Lander, which was later substantially amended when the Bun- desbank was created, several years after the end of World War II. The commercial past of practically all of the European central banks is not without significance. Though it would be conceivable, in no country was the monetary function entrusted to a ministerial department or a government agency. I believe that, in a sense that is more than symbolic, central banks must be "market" participants, "market" operators. As Mr. Volcker reminded us, central banks existed even before the words "monetary policy" had been invented. Their original mission was to regulate the issue of fiduciary money, "paper" currency, to appropriate the seigniorage, to teach people how to use bank notes and not solely coins, and most important to avoid "financial crises," the sudden scarcity of means of payments that had periodically plagued nascent industrial economies. Whatever their precise legal form and organizational structure, experience teaches us that to be successful in the discharge of their responsibilities, central banks must be "influential" and "autonomous." Both characteristics are closely interconnected. When I say autonomous, I mean not only that the central bank should not be subjected to instructions from the political authority, but that it should be financially independent and not have to rely for its operations on funds from the state budget. As both Mr. Mancera and Mr. Volcker underlined, in the final analysis, the influence and the autonomy of the central bank do not rest upon legal arrangements but on public opinion. The government must be convinced that in case of conflict with the central bank, public opinion would side with the cental bank. The governor must be keenly aware of the conditions and the limits of such public support. The question is, How does the central bank acquire and maintain influence and autonomy? In this context I see four considerations that

©International Monetary Fund. Not for Redistribution lean Godeaux 77 deserve comment. In the first place, the central bank must acquire and display expertise and professionalism. This depends on the quality of research that is done in the central bank and on its ability to communicate effectively. This requires high-quality recruitment, freedom to determine salary scales and career "profiles." Central bank personnel should have a profile distinct from that of civil servants. It means also that at the top there should not be political appointees, I should say "purely" political appointees, for nobody can deny that appointments to important positions can never be entirely devoid of some political significance. In my country, Belgium, of the six governors that have held office since World War II, five had been central bank officials at one point in their careers. A second element is the ability to be and to be seen as objective and nonpartisan. A third important factor in the success of the central bank is what I might call "political savvy." The central bank must be close to the political process but not part of it. The days of "splendid isolation" are past. One way to achieve this is to have regular contacts between the minister of finance and the governor. I am struck by the fact that in all cases that I know, there is a weekly meeting, sometimes at lunch, but in all cases in surroundings that do not create the impression of subor- dination of one party to the other. A fourth area that deserves comment is what is generally referred to as "accountability." No doubt, in a democratic system, such important powers and responsibilities as are entrusted to the central bank cannot make the bank sole master and judge. Systems do differ; there is no perfect system. In the end, as already said, public opinion must be the judge. Reporting—extensive reporting—and frequent communication are essential. A counterpart of this autonomy and "diffuse" accountability to the public at large is, I believe, what we call in French l devoir de reserve. The government should not feel or fear that the gvernor would be a rival before the media. The system that exists in my country may be illustrative of this mixture of tradition and cautious evolution that characterizes the organization and structure of central banks. Under our statutes the bank is "governed, conducted" (dirigee) by a governor; it is "administed, managed" (administree) by an Executive Committee (Comite de di tion), chaired by the governor. This committee consists of a minimum of three and a maxiumum of six directors, appointed by the King, upon a proposition by the Board of Regents. There is no legal definition of diriger and administrer. The governor thereby has considerable leewy and precedence, but an element of collegiality is still involved, which is important as Mr. Volcker remarked.

The statutes provide further that the governor and the Executive Committee are "assisted" by a Board of Regents. This Board is chaired by the governor and consists of the members of the Executive Commit- tee plus ten regents who are selected according to a complex procedure that ensures that the various economic and social constituencies of the country are represented. There is in addition a committee of censors, in effect a board of auditors. Together, these persons form the general council of the bank, which meets once a month. Finally, there is the general meeting of shareholders: the state owns half the shares and the general public holds the other half. In addition, there is, and this is important, a commissioner of the government, a civil servant who attends the meetings of the Board of Regents and has the power to suspend and refer to the minister of finance all decisions of the bank that he deems are contrary to the law, to the statutes, or to the interests of the state. In legal terms, this means that the government could prevent an action by the bank with which it does not agree, but it does not have the power to impose any action on the bank. Since the creation of the bank, this veto power has, to my knowledge, never been exercised. But the fact that it exists gives added impetus to having close and effective informal cooperation between the government and the bank. There is, I believe, no special merit to this somewhat complicated structure. It grew out of history. I may add that when the bank was created in 1850, it was set up by an act of Parliament, before a general company law existed. According to the ideas of the time, limited companies should exist only for a limited time; the bank was created to exist for thirty years. Therefore every thirty years Parliament had to adopt a new act extending the life of the bank and renewing its privilege of issue. This was not convenient. It made it necessary to have a parliamentary debate on the bank and, of course, on money and monetary policy at a time that was not necessarily the most opportune. When our last period of legal life was approaching its end on De- cember 31, 1988, we suggested that this limitation that was no longer applicable to commercial companies should be abolished. The minister of finance agreed and the act, including this feature, was voted on and approved, practically unanimously, by Parliament. The act included provisions relating to the disposition of possible capital gains on gold sales from the reserves of the bank. This possible profit had to remain invested within the bank. Only the income on such investments would accrue to the state. In this way every temptation would be avoided to sell part of the gold reserves simply to make a paper profit for the treasury. By implication, the act confirmed that the external reserves were owned by the bank and were managed by the bank in full autonomy.

What is important in this context is that the bank could easily convince the minister of finance and their "joint" proposal was quickly and unanimously approved by Parliament, including the opposition parties. This, to me, is an illustration of the influence and autonomy that the bank has achieved. That is why I have used some of your time to relate it. I wish to end on a less parochial note. When the Delors Committee described the institutional arrangements that, in their unanimous view, would be appropriate for the future European central bank, they underlined independence and accountability as the two essential elements in the status of the system. As for the suggested structure and organization, it may be useful to quote the relevant passage (p. 19) of the report: • A federative structure, since this would correspond best to the political diversity of the Community; • establishment of an ESCB [European System of Central Banks] Council (composed of the Governors of the central banks and the members of the Board, the latter to be appointed by the European Council), which would be responsible for the formulation of and decisions on the thrust of monetary policy; modalities of voting procedures would have to be provided for in the Treaty; • establishment of a Board (with supporting staff), which would monitor monetary developments and oversee the implementation of the common monetary policy; • national central banks, which would execute operations in accordance with the decisions taken by the ESCB Council. It is evident that from what you have heard and from what I have quoted a wide consensus emerges on the topics of this session.

SUMMARY OF DISCUSSION

RICHARD D. ERB First, given the role and responsibilities of a central bank it should not be surprising that all agreed on the need for a strong central bank. A number of characteristics were discussed, characteristics that made a strong central bank. Autonomy was seen as crucial, and this meant not being subject to instructions of a political authority and being financially self-sufficient and not dependent on budget appropriations. Legal independence was seen as desirable, although it was pointed out that legal independence is not necessary, nor is it a sufficient condition to create a strong central bank. A second characteristic, and this is a counterpoint to autonomy, was the need for a central bank to have a strong sense of public accountability. Autonomy does not mean that a central bank is not

©International Monetary Fund. Not for Redistribution 80 STRUCTURE OF THE CENTRAL BANKfffffffffff accountable. The speakers stressed a number of things, including the need to explain policies to the rest of the government and the general public. They also stressed that while it is important to not be political, there is a need to be sensitive and aware of the general social, political, and economic context within which monetary policy is conducted. It was also recognized that accountability means being subject to a test of public support, and the public will very often send, through the financial markets, a clear signal when it is not happy with monetary policy. Ultimately, that signal is an unwillingness to hold the currency. Another characteristic of a strong central bank is a high-quality professional staff and decision-making body. Two other characteristics mentioned were the importance of having continuity—in the structure, in the staff, in the decision making of a central bank—and integrity. There was some discussion of the relationship between a central bank and the rest of the government. Autonomy does not mean an absence of contact with other government officials. Indeed, regular contact was seen as essential, particularly with important ministries, such as the ministry of finance; meetings with legislators or political bodies are part of the process of achieving understanding and thus ensuring achievement of accountability. There was also some discussion of the relationship between the central bank and its regional branches. There was agreement that monetary policy belongs to the central bank; monetary policy decisions cannot be decentralized by cities or by regions. Regional branches, however, can be very useful in providing information about regional developments and in communicating with the public. Another view was that it is best if regional branches are not co-terminous with political units but rather cut across political units. I mentioned earlier the emphasis placed on the need for a professional central bank. This means recruiting the best people, having a career-based organization, providing a reasonably competitive salary structure, and providing an environment for open discussion of issues within the bank. Now, when it comes to those who make the major policy and operating decisions, it was thought that a collective decision-making body was best. That would mean vesting such decisions in the hands of a board rather than a single individual. It was pointed out that in most countries, boards are generally appointed by political authorities but are usually subject to procedures that provide some insulation from political pressure. This included, for example, long terms with tenure, staggered terms of appointment, and emphasis on professional qualifications. Those are some of the highlights of the discussion. Since this session concludes this phase of the conference, I would like to thank those of you who have participated in the discussions.

RICHARD D.ERB

aa For two days we have had an intensive discussion of the experience of central banking. We have had four sessions: the first, on the role of monetary policy, the second, on implementing monetary policy, the third, on the role of supervision and regulation, and the fourth, on the structure and responsibilities of the central bank. Each session began with a presentation by the People's Bank of China. Governor Li gave a presentation on the role of monetary policy; Deputy Governor Zhou spoke about the implementation of monetary policy; Deputy Governor Tong spoke of the role of supervision and regulation; and Deputy Governor Chen addressed the structure and responsibilities of the central bank. Each of those presentations provided a good starting point for the discussions. The presentations were then followed in each case by a presentation by Mr. Volcker, Mr. Mancera, and Mr. Godeaux. A give-and-take discussion then followed the formal presentations, which allowed an exchange of views. I would like to draw from some of the major issues that were discussed during the conference. With respect to the question of what key objectives should guide economic policy and the role of the central bank in that context, everyone understood that every government faces multiple objectives. These include growth, development, full employment, external equilibrium, price stability, and an equitable income distribution. A key question for the meeting was in what way can the central bank contribute to the achievement of these objectives. It was agreed by our speakers that the best contribution a central bank can make is to assign priority to the achievement of price stability. By contributing to the achievement of price stability, the central bank is helping to lay the basis for prudent savings, investment, and exchange rate stability. All of these are seen as crucial to economic growth and development. Another theme that came out of the discussions concerned the general environment within which monetary policy is set. Monetary policy implementation, and its success in achieving price stability in a country, depends importantly upon the structure of the economy and also on other economic policies. Some of the key structural factors

©International Monetary Fund. Not for Redistribution 82 CONFERENCE SUMYjjjhjj mentioned included the degree of price and wage flexibility and the savings rate for the population as a whole. Among other government policies, fiscal policy was seen as especially crucial. Drawing on the experience of a wide range of countries, the conclusion was reached that excessive fiscal deficits can make the implementation of monetary policy much more difficult, by putting pressure on a central bank to finance the deficit directly or indirectly. In addition, experience indicates that fiscal deficits can crowd out other productive investments and lead to excessive foreign borrowing. In looking at this relationship between monetary policy and fiscal policy, there was the view that the central bank and the finance ministry should be natural allies and that in dealing with overall economic conditions they should work together, particularly in resisting expenditure pressures from other government bodies. A third conclusion was that continuity in monetary policy was important. Indeed, continuity not only in monetary policies but also in other macroeconomic policies was seen as important. What were referred to as stop-and-go cycles of expansion and contraction will weaken the confidence in government economic policies and undermine the climate for savings and productive investment. In this context, reference was made to the experience of many other countries, particularly in the 1970s, and the consequences of stop-and-go policies. All of our speakers agreed that a stable environment was the most conducive to economic growth. Theories to the effect that inflation and growth go hand in hand have not been borne out in practice. In many governments, there was the temptation to say that "a little bit more inflation may be okay if we get growth." But as many governments found, particularly in the 1970s, yielding to that temptation led to accelerating inflation, and eventually growth prospects were under- mined. It was also indicated that day-to-day decisions on monetary policy should be made within the context of a medium-term framework that is developed, for example, on an annual basis. Yet another subject discussed in the conference concerned the role of the financial markets. The broadening and deepening of financial markets was seen as facilitating the implementation of monetary policy. In addition, the broadening and deepening of financial markets and the removal of obstacles to the development of and competition among financial intermediaries contribute to the allocation of credit to the most productive uses. There was a strong view that the central bank should not directly involve itself in credit allocation. To the extent that a governmental role in credit allocation was deemed desirable, it should be accomplished through the budget and not through the central bank.

There was a common view among our speakers that over time most credit would best be allocated by the market. But there are circumstances, of course, in which almost all governments seek to influence the direction of credit flows. Another subject on which some interesting conclusions were developed concerned the role of regulation and supervision. There was broad consensus that regulation and supervision were essential for monetary policy and a healthy financial system. Supervision entails not only the enforcement of rules and regulations but also judgments concerning the soundness of the financial institutions' assets, and judgments on the capital adequacy and the quality of the financial institutions' management. The central bank has a strong interest in these matters and at a minimum should be responsible for the issue and implementation of all regulations dealing with monetary policy. Many countries favor the central banks, being responsible for prudential supervision also. But, as in some countries, if the central bank is not responsible for this aspect, it should at least have a strong presence in the supervisory process. Finally, among some of the last major issues discussed, you will not be surprised to hear that, given its responsibilities, a central bank needs to be strong. What does this mean? It means that a central bank should be autonomous and thus not subject to orders from other government bodies. A central bank should not depend on a budget allocation but rather be financially independent. But autonomy does not mean that a central bank is not accountable. Accountability means that a central bank must be sensitive to the broad social, political, and economic environment within which monetary policy is set. Accountability means that a central bank must make every effort to explain its policy to other parts of the government and to the general public. Beyond the importance of autonomy and accountability, a strong central bank should have a high level of technical expertise and be professional and nonpartisan. These are some of the highlights of the points that were made during the discussions. Of course, it is not possible in a brief summary to convey the full richness of the discussions and all the nuances and qualifications that one would associate with some of these conclusions, which are put more starkly.

PAUL A. VOLCg a Let me say from the perspective of a large developed country that has had to deal with many other countries around the world, financially as well as politically, in many different circumstances, that for a

developing country, a strong central bank has considerable advantages as it more and more develops financial and economic relations with the rest of the world. By a strong central bank, I reiterate those factors that Mr. Erb mentioned: an organization respected for its professionalism, for its integrity, its nonpartisanship, and with a high degree of continuity. An organization of that sort becomes a trusted point of contact with other central banks, indeed, with other financial agencies around the world, with private bankers, and others. We like to think that international economic relations proceed smoothly all the time, but it is obvious they do not. Various problems arise—great uncertainty sometimes, financial disturbances, a certain amount of antagonism sometimes—between countries. History tells us this is inevitable. One other point is that Mr. Erb has properly emphasized the emphasis we put on the central bank concerning itself with achieving reasonable price stability. In that connection, I think that we three visiting central bankers all speak from some experience. Experience not of perfection but of experience with, in varying degrees, serious inflation. We have found firsthand the difficulties that creates. I want to acknowledge that in emphasizing that point, we are speaking as much to ourselves as to you. My sense is that you have properly attached a lot of priority to restoring price stability, that your record over the years has been pretty good, by world standards, and that your very recent efforts over the past year or eighteen months have clearly borne fruit in restoring a high degree of stability. I raise one question in that connection. We emphasized also the need for restoring more flexibility to the economy. That means among other things liberalizing and reforming the price system. We recognize that sometimes reform of the price system means more increases in prices in the short run than the kinds that create certain risks. You have a far better environment today, it seems to us, for dealing with questions of liberalization than when you were in the midst of strong inflationary pressures a year or two ago. There is some evidence that the overall price level is being stabilized.

MIGUEL MANCERA s 1 would like to emphasize the importance of competition for the good functioning of a market economy. In the conclusions that were read by Mr. Erb, there was mention of competition. But I would like to point out that this is an element absolutely essential for the good working of a market economy. If competition is not present, and, instead, we have monopolistic or oligopolistic arrangements in industry, banking included, we cannot expect a market economy to work well. It is true

©International Monetary Fund. Not for Redistribution Jean Godeaux 85 that in very few instances in the world do we find what the textbooks call perfect competition. In this world nothing is perfect, but we should try to make things as perfect as possible, or as near perfect, and, in that sense, if you decide to have a part of your economy governed by market rules, it is essential that you foster competition as much as possible. If this condition is not met, you may be disappointed by the market economy.

JEAN GODEAUX ass 1 here is not much to add after the very balanced summary that has been made and the additional comments that my two colleagues have made. I should like to add the following. It is a well-known fact of political science that the art of government is to reconcile objectives, desires, and interests that are multiple and cannot be all achieved at the same time. Economic policy is only part of the general policy. We therefore have to be aware that there are other considerations that are important and are outside the realm of economic policy. We know also that monetary policy to be effective can only be a part of a more general economic policy. Some observations have been made that have universal validity. One is that price stability is not inimical to the other objectives of economic policy. On the contrary, experience in all sorts of countries has shown that one cannot durably "buy" growth by accepting to pay a price in terms of a higher rate of inflation. In industrial countries, in developing countries, in large countries, in small countries, everywhere, this observation has been made. Another observation that has been made is that the importance of price stability and its contribution to the achievement of the other goals of economic policy is enhanced if one special institution is entrusted with monetary policy and is given the priority task of fostering price stability. Within this framework, useful lessons can be drawn from the observations that have been made. These observations permit lessons that are of general validity. I should think that, as has been observed already, in the particular circumstances of China the conditions exist for pursuing this line of reasoning without excessive difficulty, even though we all know that nothing is easy. There are no painless policies and, as our American friends say, "there is no such thing as a free lunch." Everything has a price. Monetary policy is neither easy nor painless. But it can be a powerful aid to good economic policies.

Chairman BAI Mei Qing Richard D. Erb Deputy Secretary General Deputy Managing Director General Office of the State Council International Monetary Fund BIAN Yao Wu Co-Chairmen Vice Governor LI Guixian Qinghai Province Governor People's Bank of China CAI Ning Ling Vice Minister of Materials Roy D. Morey Resident Representative DAI Xiang Long United Nations Development President Programme Bank of Communications

Speakers HAO Jian Xiu Paul A. Volcker Vice Chairman Former Chairman of the Board of State Planning Commission Governors of the Federal Reserve System HE Kang Minister of Agriculture Miguel Mancera Governor HUANG Da Central Bank of Mexico Vice President jean Godeaux People's University of China Former Governor Jl Yun Shi National Bank of Belgium Vice Governor TONG Zengyin Jiangsu Province Deputy Governor People's Bank of China JIN Xin General Director ZHOU Zhengqing State Administration of Taxation Deputy Governor People's Bank of China LI Dao Yu CHEN Yuan Assistant Minister of Foreign Affairs Deputy Governor People's Bank of China LI Xiang Rui Senior Advisor Participants Shanghai AN Cheng Xin Deputy Secretary General LIU Sui Nian General Office of the State Council Minister of Materials

LIU Hong Ru WANG Min Quan Deputy General Director Vice Mayor State Commission for Restructuring Wuhan the Economic Systems XIANG Huai Cheng LONG Yong Tu Vice Minister of Finance Deputy Director China International Economic and XU Zhao Long Technical Exchange Center Vice Chairman LU Pei Jian China International Trust and Auditor General Investment Corporation (OTIC) Audit Administration of PRC YAN Yin MA Hong Deputy General Secretary General Director General Office of the State Council The State Council Development Research Center ZHANG Hong Yi Vice Mayor MA Yong Wei Shenzhen President Agriculture Bank of China ZHANG Jian Min QIN Dao Fu Vice Mayor General Manager Beijing People's Insurance Company of China ZHANG Pan Deputy General Director SHANG Ming The State Council Development Special Adviser Research Center People's Bank of China Zhang Qi SHAO Zong Ming Deputy General Director Deputy Gernal Director The State Price Bureau The State Statistics Bureau ZHANG Sai SHEN Jue Ren General Director Vice Minister of Foreign Economic The State Statistics Bureau Relations and Trade ZHANG Shi Yao SUN Tong Chuan Vice Minister of Commerce Major Chongqing ZHANG Xiao TANG Gen Yao President General Director Industrial and Commercial Bank of The State Administration of Foreign China Exchange ZHENG Li WANG Chang Bai Deputy Auditor General Vice Minister of Agriculture Audit Administration of PRC

WANG De Yan ZHENG Tuo Bin President Minister of Foreign Economic Bank of China Relations and Trade

ZHOU Dao Jiong Linda M. Koenig President Senior Advisor Construction Bank Asian Department of China International Monetary Fund Gyorgy Szapary ZHU Jia Zhen Assistant Director Vice Governor European Department Liaoning Province International Monetary Fund