Occasional Papers of the International Monetary Fund · 2019. 12. 11. · Occasional Papers of the International Monetary Fund *1. International Capital Markets: Recent Developments

Occasional Papers of the International Monetary Fund

*1. International Capital Markets: Recent Developments and Short-Term Prospects, by a Staff TeamHeaded by R.C. Williams, Exchange and Trade Relations Department. 1980.

2. Economic Stabilization and Growth in Portugal, by Hans O. Schmitt. 1981.

*3. External Indebtedness of Developing Countries, by a Staff Team Headed by Bahram Nowzad andRichard C. Williams. 1981.

*4. World Economic Outlook: A Survey by the Staff of the International Monetary Fund. 1981.

5. Trade Policy Developments in Industrial Countries, by S.J. Anjaria, Z. Iqbal, L.L. Perez, andW.S. Tseng. 1981.

6. The Multilateral System of Payments: Keynes, Convertibility, and the International MonetaryFund's Articles of Agreement, by Joseph Gold. 1981.

7. International Capital Markets: Recent Developments and Short-Term Prospects, 1981, by a StaffTeam Headed by Richard C. Williams, with G.G. Johnson. 1981.

8. Taxation in Sub-Saharan Africa. Part I: Tax Policy and Administration in Sub-Saharan Africa, byCarlos A. Aguirre, Peter S. Griffith, and M. Zuhtu Yucelik. Part II: A Statistical Evaluation ofTaxation in Sub-Saharan Africa, by Vito Tanzi. 1981.

9. World Economic Outlook: A Survey by the Staff of the International Monetary Fund. 1982.

10. International Comparisons of Government Expenditure, by Alan A. Tait and Peter S. Heller.1982.

11. Payments Arrangements and the Expansion of Trade in Eastern and Southern Africa, byShailendra J. Anjaria, Sena Eken, and John F. Laker. 1982.

12. Effects of Slowdown in Industrial Countries on Growth in Non-Oil Developing Countries, byMorris Goldstein and Mohsin S. Khan. 1982.

13. Currency Convertibility in the Economic Community of West African States, by John B.McLenaghan, Saleh M. Nsouli, and Klaus-Walter Riechel. 1982.

14. International Capital Markets: Developments and Prospects, 1982, by a Staff Team Headed byRichard C. Williams, with G.G. Johnson. 1982.

15. Hungary: An Economic Survey, by a Staff Team Headed by Patrick de Fontenay. 1982.

16. Developments in International Trade Policy, by S.J. Anjaria, Z. Iqbal, N. Kirmani, andL.L. Perez. 1982.

17. Aspects of the International Banking Safety Net, by G.G. Johnson, with Richard K. Abrams.1983.

18. Oil Exporters' Economic Development in an Interdependent World, by Jahangir Amuzegar. 1983.

19. The European Monetary System: The Experience, 1979-82, by Horst Ungerer, with Owen Evansand Peter Nyberg. 1983.

20. Alternatives to the Central Bank in the Developing World, by Charles Collyns. 1983.


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©International Monetary Fund. Not for Redistribution

Occasional Paper No. 20

Alternatives to the Central Bank inthe Developing World

By Charles Collyns

International Monetary FundWashington, D.C.

July 1983


International Standard Serial Number: ISSN 0251-6365

Reprinted July 1984

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


Contents

Page

Prefatory Note v

I. Introduction 1

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

III. The Role of Central Banking in Developing Countries 5The Objectives of Monetary PolicyFinancial Structure and Monetary OperationsSocial and Political Constraints on Central Banking

IV. The Transitional Central Banking Institution 10FijiMaldives and Bhutan

V. The Supranational Central Bank 13The West African Monetary Union and the Central

African Monetary AreaEast Caribbean Currency Authority

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

VII. The Central Banking Institution in an Extremely Open Economy 18Singapore and Hong KongKuwait, Saudi Arabia, and the United Arab Emirates

VIII. Conclusion 21

TABLE

Section

VIII. 1. Alternative Central Banking Institutions 22

REFERENCES 23

iii


The following symbols have been used throughout this paper:

to indicate that data are not available;

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

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

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

"Billion" means a thousand million.

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


Prefatory Note

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

V


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I Introduction

A national central bank is usually high on the shoppinglist of a newly independent country. Such a country ofteninherits a currency board—a carryover from the colonialera—and wishes to establish a new monetary authoritywith far wider executive powers and public responsibili-ties. Although the principal motives for acquiring suchan institution may well be profit and prestige, centralbanking consists of much more than printing money andattending international conferences. Central banks indeveloped countries typically conduct a broad array ofbanking, regulatory, and supervisory functions. In adeveloping country, however, the problems and opportu-nities facing the monetary authority may be radically dif-ferent from those encountered in the developed world. Inrecognition of this fact, not all of these countries havechosen to set up a full-fledged central bank: many havepreferred alternative institutional arrangements. Whileinevitably a number of common formulas have beenapplied in designing such new forms of monetary author-ity, central banking legislation has generally beenadapted to fit national needs, capabilities, and aspira-tions, while the practical execution of a blueprint hasoften been gradual and idiosyncratic. The result is a widerange of central banking institutions and a correspond-ing variety of objectives, constitutional powers, policyinstruments, and relations with central governments.This paper surveys the alternative institutional forms thathave emerged and seeks to explain the observed diversityof experience.

Some definitions are useful at the outset. The term"central bank" is used in this paper to refer to an institu-tion bearing the full panoply of executive powers andpublic responsibilities that is usually implied by thatname; this generic sense is clarified in Section II of thispaper. The terms "central banking institution" and"monetary authority" are used here synonymously torefer to institutions that undertake responsibility for anyof the functions characteristic of the central bank or forany other activity involving the management or regula-tion of some aspect of the financial sector of the economyin the public interest. Various generic types of centralbanking institutions will be described in Sections IV-VIIof this paper, including the "transitional central bankinginstitution," the "supranational central bank," the "cur-

rency enclave central banking institution," and the"open economy central banking institution." The "cur-rency board" is a further example of a central bankinginstitution. It should be noted that the title of an institu-tion need not be an accurate guide to that institution'scharacteristics: central banks may exist in name but notnature, and vice versa.

The plan of this paper is as follows: Section II providesa brief analysis of the rationale for the various centralbanking activities and for their establishment in a single,operationally independent institution within the generalcontext of the developed world. Section III gives a broadpicture of the particular problems and opportunities fac-ing central banking institutions in developing countries.It focuses on the scope for monetary policy in a relativelysmall, specialized economy, on the links between mone-tary operations and the domestic financial structure, andon social and political constraints on the monetaryauthorities' actions. Together these two sections providethe analytical background to the survey of alternativeinstitutions that follows. Each of Sections IV-VII openswith a general discussion that attempts to characterize aparticular class of central banking institutions as a partic-ular response to a certain set of problems and opportuni-ties, and goes on to describe actual examples of monetaryauthorities that, at least in some respects, correspond tothe polar form. Section IV examines transitional centralbanking institutions that are intended to provide steppingstones between the currency board or some other rudimen-tary institution and the full-fledged central bank. SectionV discusses examples of monetary unions in which respon-sibilities for central banking in a group of countries aredelegated to a single supranational institution. Section VIis concerned with the alternative forms of monetaryauthority possible in countries in which the dominantmeans of transaction is a foreign currency, and whereresponsibility for at least some central banking activitiesmaybe transferred to an external agency. Section VII dealswith central banking institutions in extremely open econo-mies in which most, if not all, restrictions on trade andcapital flows have been removed and in which the financialsector is itself a focus of economic growth. Section VIIIconcludes the paper.

1


II The Rationale for Central Banks

Central banks in the developed world are given a widerange of public responsibilities and endowed with a corre-spondingly broad array of executive powers. The activities ofthese institutions can be grouped into five general functions:

Currency issue and management of foreign reserves

Provision of a national currency involves the physicalproduction and distribution of notes and coins, operationsin foreign exchange markets to guide the currency's ratesof exchange with other currencies, and the management ofthe reserves of foreign assets held to sustain the nationalcurrency's external value.

The role of banker to the government

This function involves providing bank deposit and bor-rowing facilities to the government and acting as fiscalagent and underwriter for the government. It also includesgiving technical advice to the government on monetarypolicy and financial affairs.

The role of banker to domestic commercial banks

This function normally includes the acceptance ofdeposits to act as prudential reserves for these banks, thewillingness to discount commercial and government paperfor these banks, and the commitment to act as lender oflast resort to these banks. It may also involve the provisionof central clearance facilities for interbank transactions.

The regulation of domestic financial institutions

This activity involves ensuring that commercial banksand other financial institutions conduct their businesseson a sound, prudential basis and according to the variouslaws and regulations in force. It includes the monitoring ofreserve ratio requirements and the supervision of bankingconduct.

The operation of monetary and credit policy

This function involves the manipulation of monetaryand credit policy instruments in seeking to achieve thegovernment's chosen macroeconomic strategy and/or con-stitutionally mandated objectives. This task may requireactions to influence monetary aggregates, exchangerates, interest rates, and the distribution of credit.

A satisfactory rationale for central banks must logi-

cally proceed in two stages. First, it is necessary toexplain why it may be advantageous for certain activitiesin a financial system to be performed by institutions withexplicit public responsibility rather than left to the mar-ketplace. Second, one needs to argue that these functionsshould be entrusted to a single centralized authoritywhich is discrete from, rather than an integral part of, thegovernment. This section provides such a rationale for acentral bank within the general context of a typical devel-oped country; it presupposes a country with a complexeconomy, a sophisticated financial system, and a well-educated population.

Why Central Banking Institutions?

All of the functions described above are intended tocontribute to the efficiency and stability of a financial sys-tem that is conducive to overall economic prosperity.Reasons may be given to believe that in each case thefunction would be more effectively performed by a pub-licly responsible body than by private institutions seekingtheir own ends.

Regarding currency issue, money ideally serves as aconvenient means of exchange, as a secure store of liquid-ity, and as a stable unit of account. The provision of anational fiat currency allows the seigniorage 1 obtainedfrom currency issue to accrue to the home country. Intheory, each domestic commercial bank could be permit-ted to issue its own currency without the home countryforfeiting the advantage of seigniorage. Indeed, it may beargued that it would be appropriate to give commercialbanks the right of fiduciary issue; this would permit mar-ket forces to act to ensure the efficient provision of cur-rency.2 Under such an arrangement a person's desire tohold a particular bank's currency would depend on theconvenience of use of that currency and on the stability ofits exchange value. Banks would earn seigniorage to theextent that their own currency possessed these properties.

1Seigniorage is used in the broad sense to refer to the pecuniary benefitderived from the issue of notes and coins as noninterest-bearing liabili-ties rather than in the narrow sense of the excess of the monetary over thebullion value of coinage.

2See, for example, Hayek (1976).

2


Why Central Banks?

One flaw in this argument lies in the economies of scaleinherent in the production of and, crucially, the use offiat money. There would be a strong tendency for one pri-vate currency to dominate the rest because of the reducedtransactions costs associated with the use of a commoncurrency, which would be immediately recognizable,readily disposable, and the unit of account. However,once such a monopolistic position were established, thediscipline of the market would no longer constrain theissuer of currency to be efficient.

The position of banker to the government is a powerfulone. It is clearly important for the government to haveaccess to specialized financial expertise untainted by theinfluence of any outside interest. In addition, the govern-ment's typical scale and central position in the economywould require that its banker take due account of itsimpact on the economy, particularly in decisions on howfar to finance the government's credit requirements.

The functions of banker to domestic commercial banksand of regulator of these banks' behavior are closelylinked. These activities are directed toward two basicobjectives. The first is to safeguard the stability of indi-vidual banks. Without central regulation, bank cus-tomers could face considerable problems in ascertainingthe relative security offered by different banks' services.The imposition of reserve ratio requirements and thesupervision of banking conduct are intended to ensurethat the supervised financial bodies all maintain a certainstandard of security, on which their customers may thenrely.3 At the same time, individual bank stability contrib-utes to the stability of the financial system as a whole.Problems may arise when individual banks within the sys-tem are heavily indebted to each other. Then the fate of aparticular bank may have repercussions throughout thefinancial system that individual lenders fail to take intoaccount. Central provision of lender-of-last-resort anddiscounting facilities can recognize these repercussionsand, hence, reduce the chances of bank failure spreadingthrough the system.

Aspects of each of these broad functions—in particu-lar, the issuing of currency, the holding of governmentdebt, the setting of reserve requirements, and the stanceof the lender of last resort—have strong implications forthe exchange rate, domestic interest rate conditions andthe availability of credit, and hence for economic activity.The use of monetary policy to influence macroeconomicconditions is, of course, a highly controversial and widelydebated topic. To simplify, most economists would prob-ably accept that if domestic labor and product marketswere not fully competitive and responded slowly to shiftsof the economic environment, there would be scope for

3With a system of deposit insurance in place to protect depositors,regulation would still be required to ensure that banks attained the mini-mum standard of security necessary to ensure the viability of the insur-ance scheme; see Giddy (1982).

policy intervention to speed adjustment to externalshocks to the economic system even if financial marketswere both competitive and stable. The key issue is thenwhether the costs and uncertainties involved in suchaction in practice do not outweigh the potential benefits.While many economists believe that countercyclical inter-vention can be effective in certain circumstances, othersare more skeptical, and would argue that monetary policyshould be primarily concerned with the preservation(or restoration) of a stable and predictable monetaryenvironment.

Why Central Banks?

Central banks are organizations that fulfill two crite-ria: (1) they undertake most of the functions ascribedabove to central banking institutions (at least acting asissuer of currency, banker to the government, and bankerto commercial banks); and (2) they exercise considerablediscretion in the choice of the means if not the objectivesof their operations.

The benefits of establishing many of the central bank-ing functions within a single entity are easily explained.First, there are economies of scale to be gained fromentrusting these functions to one organization that maydevelop a considerable body of financial knowledge andexpertise. Second, the close links between the functionsmake it advantageous to establish a single body, withwide-ranging powers of investigation and execution, to beheld responsible for the overall functioning of the finan-cial system. In practice, the range of functions under-taken by central banks does vary even between developedcountries, but the functions that are sometimes incorpo-rated in separate institutions are usually specializedones—such as the physical production of currency, theprovision of deposit insurance, and the licensing of finan-cial institutions—that are not central to the operationaltask of financial management.

The reasons for the typical operational independenceof the central banking institution are again mainly practi-cal ones. Clearly, for the central banking institution tomake rapid and flexible responses to a fluid financialenvironment, it must have at least day-to-day operationalindependence. It is true that such limited independencewould not preclude the central banking institution being,for example, merely another section of the finance minis-try; but independence from the finance ministry may bedesired as a check and a balance to that ministry in theanalysis and formulation of economic policy. Even so,such independence would not be incompatible with thecentral banking institution being embodied, for example,in a separate ministry of monetary affairs whose ministersat in the cabinet. However, a clear separation from thegovernment altogether would make it easier for the cen-tral banking institution to establish close links with thefinancial community.

3


II • THE RATIONALE FOR CENTRAL BANKS

A more controversial issue is the question of whetherthe central banking institution should be subject, in thelast resort, to the decisions of the central executive officeof government. The orthodox view would be that mone-tary policy, as an important lever of power, should ulti-mately be subject to democratic sanction; while the cen-tral banking institution may be given a separate voice inpolicy debate, the final voice should belong to the repre-sentative government. The opposing view would empha-size that monetary policy—like the administration ofjustice—must be able to resist undue political pressures.It can be argued, for example, that central banking insti-tutions should be constitutionally mandated to seek thelong-run objective of monetary stability on the groundsthat permitting political guidance of policy objectiveswould inevitably lead to policy actions designed toachieve short-run advantages to the ultimate detriment ofthe economy. Such arguments hinge on the view that theelectorate itself would be shortsighted in exercising itschoice of government and on the economic theory thatonly unanticipated monetary policy would provide aneffective instrument to manipulate domestic output andemployment.4 But even if it were to be determined thatfull independence would be desirable in principle, itwould still be necessary to establish an institution that

would indeed be capable of standing against both politi-cal and popular pressures.

In practice, the central banking institution's degree ofindependence from government does vary considerablyeven within the developed world.5 The constitutionallyguaranteed independence from the executive of the Fed-eral Reserve Board and the Deutsche Bundesbank maybe contrasted with the Bank of England's customaryindependence in the operation of monetary policy but notin the selection of goals and with the close supervisionexperienced by the Bank of France. It should be notedthat both the United States and the Federal Republic ofGermany have federal political structures in which con-stituent states provide a counterweight to the central gov-ernment. Also, independence de facto would depend, atleast in part, on the personalities of the senior politicians,civil servants, and central bankers involved and on the sup-port each group would receive from the banking estab-lishment and elsewhere.

Central banks could be classified by assessing (1) theirinvolvement in the execution of each of the tasks specifiedabove, and (2) the degree of independence exercised inthe execution of each of these tasks. For the present pur-poses, it is sufficient to concentrate on an ideal or arche-typal "full-fledged central bank" that is characterized asbeing fully involved in each of the five typical functions ofthe central banking institution and also as having consid-erable, if not complete, discretionary powers to under-take these functions.

4For a neat if simplistic illustration of such an argument, see Kydlandand Prescott (1977).

5For a survey of the degrees of independence exercised by centralbanks in 16 developed countries, see Fair (1979).

4


The discussion of Section II presupposed a complexeconomy, a sophisticated financial system, and a well-educated population. The situation in a developing coun-try when it chooses its central banking institution may bevery different. Its economy may be dominated by a lim-ited range of exports and faced by terms of trade beyonddomestic control. Its financial system may be rudimen-tary, based on foreign-owned commercial banks financ-ing commerce and export industries, an informal creditnetwork serving much of the rural economy, and aninherited central banking institution which is essentiallya currency board. Its population may be short of workerstrained in the technicalities of finance and relatively unso-phisticated in appreciating the economic realities of a situ-ation. In these circumstances, an overriding considerationmust be to ensure that the new monetary authority will beable to establish credibility as a responsible and effectivebody that is capable of instilling domestic and foreign con-fidence in the domestic currency and financial system. Atthe same time, it must be accepted that the new institutioncannot hope to undertake immediately all of the functionsof the full-fledged central bank, while the scope for centralbanking activities would be considerably different fromthat in a more developed country.

This section takes up three topics in turn. First, it con-siders the role for monetary policy in a small, developingeconomy, arguing that the objectives of monetary policyin such an economy must be less ambitious than in alarger, industrial economy. Next, it analyzes how variouscharacteristics of the financial structure in developingcountries affect the constraints and opportunities facingthe central banking institution. Lastly, it considers howthe social and political environment may limit the capa-bilities of the central banking institution.

The Objectives of Monetary Policy

In Section II, the rationale for an active monetary pol-icy was linked to uncompetitive and slowly adjustingdomestic product and factor markets. In economies domi-nated by such markets, the level of domestic demandwould play a key role in determining the levels of outputand employment. Such economies are typical of the large,

industrial countries. However, consider a small, openeconomy that exports a high percentage of output at aprice substantially independent of the level of exports andwhose import prices are fixed irrespective of desired vol-umes; its terms of trade can be taken as given. In such aneconomy, production and real income are mainly influ-enced by the costs of domestic supply and by world ratherthan domestic demand conditions. In this situation, amonetary injection that boosted domestic spending mightincrease prices and output of nontraded goods and ser-vices, but the multiplier effect would be limited by thesmall size of this sector of the economy. Inevitably thepolicy shift would result in balance of payments deficitsand loss of reserves (if the exchange rate were fixed) orgeneral inflation (if the exchange rate were allowed tofloat). In general, the greater is the openness of the econ-omy, the more difficult it is to affect the real economythrough active monetary policy.

There are both developed and developing countrieswhich may be characterized as having small, open econo-mies. In developing countries, a high degree of exportspecialization may leave the economy particularly vulner-able to such exogenous shocks as fluctuations in domesticsupply conditions or in prices in world markets. But,while the potential benefits of countercyclical action maybe substantial in such conditions, such policy is likely tobe inherently costly and difficult to execute. The loss ofreserves and the inflation associated with a reflationwould have a particularly severe impact in a developingcountry. Moreover, attempts at fine tuning would befraught with problems of control. Information andresponse lags between the first moments of a downturnand the impact of the policy response would be lengthy,while the links between policy instruments and domesticoutput would be tenuous and uncertain. In these circum-stances, it would seem desirable to place the focus of sta-bilization on the finance of those particularly affected bya shock, rather than on any attempt to offset contractionin one sector by expansion elsewhere. Such a policy must,however, be cautious if the authorities find it difficult todistinguish between temporary shocks, for which adegree of purely financial stabilization may be appropri-ate, and permanent shifts in the trading environment,

which would require eventual real economic adjustment.

5

III The Role of Central Banking in Developing Countries


III • THE ROLE OF CENTRAL BANKING IN DEVELOPING COUNTRIES

Given the difficulties involved in short-run stabiliza-tion, the main thrust of monetary policy may be betterdirected toward establishing the financial conditionsrequired by the long-run development strategy of theeconomy. In particular, in developing economies thathave opted for export-oriented growth based on free tradeand the judicious encouragement of private enterprise, itis usually advantageous to achieve a stable exchange rateregime with commitments to maintaining the converti-bility of the currency and to minimizing restrictions oncapital flows. To maintain confidence in such a system,monetary policy must be broadly compatible with adomestic inflation rate that is close to the world inflationrate and with a current account deficit that is consistentwith sustainable capital inflows. An inflation rate higherthan generally prevailing in competing countries wouldlead to a progressive loss of competitiveness, while a per-sistent balance of payments deficit would lead to rapidlydiminishing foreign exchange reserves. Both of theseeffects would lead to expectations of an eventual devalua-tion and the imposition of a less liberal exchange controlregime.

A rate of domestic inflation above world levels and anunsustainable balance of payments deficit are both symp-tomatic of high levels of expenditure relative to incomeor, equivalently, to the expansion of domestic credit at agreater rate than the growth in demand for domesticfinancial assets. The relative importance of cash andbank deposits in developing country financial sectorsimplies that the objective of financial stability requiresclose coordination between the expansion of domesticbank credit and the growth in demand for monetaryassets. Short-run discrepancies between the two may bepermitted for the sake of financial stabilization, espe-cially if official external funding can be obtained (forexample from the export earnings stabilization facility ofthe European Community or from the InternationalMonetary Fund's compensatory financing facility). But, ingeneral, financial prudence would require that care betaken to guide growth of the money supply and domesticcredit in accord with well-chosen targets.6 These targetsshould be aligned with the development strategy, so as tobe compatible with the growth of domestic savings and the

expansion of domestic credit required for the nationalinvestment program.

In addition, the authorities may seek to guide the alloca-tion of credit in accordance with development prioritiesrather than permitting commercial banks and other finan-cial institutions to place their loans as they see fit. Suchpolicies are often motivated by the belief that market fail-ures distort private incentives away from their socially opti-mal levels and would lead to misallocation of investment inthe absence of selective credit controls. Much criticism has

been directed toward such policies, however, based onskepticism over whether the market is really transmittinginappropriate signals and over whether credit controls aretruly effective or lead merely to a rerouting of funds fromother sources.

The extent to which the monetary authority can influ-ence domestic interest rates and credit conditionsdepends on the access residents can obtain to interna-tional capital markets and on the strength of preferencesfor domestic as opposed to foreign-currency denominatedassets and liabilities. If residents were able to deposit andborrow freely abroad at given world interest rates, andwere indifferent to the denomination of currency, thenthe attempt to establish independent domestic rateswould not be sustainable and monetary policy would haveto be passive. In practice, domestic wealth holders dohave a certain preference for domestic deposits becauseof their convenience and lack of exchange risk. Thestronger is this preference, the less interest elastic thedemand for domestic deposits is likely to be. Moreover,controls on outward capital mobility may be effective atincreasing the scope for monetary policy if they succeedin raising the costs of obtaining foreign deposits; theycannnot be completely watertight, however, for in anopen economy there will always remain many loopholesavailable to sophisticated opponents to evade restric-tions. At the same time, foreign lenders will wish to limitthe value of their loans to any particular developing coun-try: risks of default, costs of rescheduling, lack of localinformation and foreign exposure regulations all act toreduce the price elasticity of domestic access to foreigncredit.7 The less is the elasticity of this access, the morethe monetary authority will be able to influence the price

and availability of credit to domestic borrowers by vary-ing its own lending operations.

In economies with extensive restrictions on trade andpayments, domestic conditions will often be heavily depen-dent on the authorities' actions. Typically, such economieshave maintained overvalued exchange rates. In these cir-cumstances, scarce foreign exchange is conserved by limit-ing the issue of import licenses or by implementingexchange restrictions. In the latter case, the central bank-ing function of management of foreign exchange reservesacquires a new aspect, that of rationing these resources inaccordance with perceived national priorities.

Financial Structure and Monetary Operations

The financial structure of a small, developing countrytends to be fairly simple. Typically, the banking system isdominated by several foreign-owned commercial banks,

6See Coats (1980) for similar arguments in favor of monetary targetingin developing countries.

7Extreme smallness of a country does not by itself guarantee perfectlyprice-elastic access to foreign credit because each country's debt is effec-tively differentiated from others by its sovereign risk.

6


Financial Structure and Monetary Operations

which are branches of multinational banks rather thanlocally incorporated. Indigenous enterprises are usuallyeither owned by the government or on a relatively smallscale. Many of these smaller-scale enterprises, especially inrural areas, would be part of an informal credit networkand outside the purview of the monetary authorities.

In such a context, the instruments available for theapplication of monetary policy are considerably restricted.In more developed financial systems, central banks are ableto exercise close control over domestic interest rates or overthe availability of domestic credit through the manipulationof discount rates, through open market operations, andthrough intervention in money markets. The influence ofthese instruments depends on commercial banks being sen-sitive to changing domestic credit conditions or at least mak-ing conventional responses to policy shifts. These responsesmay be weak or even absent altogether in a financial struc-ture in which the dominant foreign-owned banks tend (1) tobe relatively liquid, (2) to prefer to resort to parent banksrather than to a central banking institution for temporarycredit, and (3) to set interest rates with oligopolistic inflexi-bility. Moreover, open market operations and interventionin money markets are unsuitable instruments for policyintervention if the markets for government securities andshort-term commercial paper are shallow; in such circum-stances, price responses would tend to be volatile andunpredictable. In addition, induced fluctuations in finan-cial prices would, by increasing the uncertainty of returns inthese markets, reduce the liquidity of financial assets, andso act to discourage would-be participants. The result wouldbe to repress the rate of development of these markets.

Monetary policy in developing countries is usually con-ducted by more direct means. Often the central bankinginstitution is given powers to regulate commercial banks'deposit and lending rates directly and to issue creditguidelines and ceilings. The central banking institutionmay also influence bank liquidity by manipulating pru-dential reserve ratios and by controlling its extension ofcredit to banks and to the government. By use of theseinstruments, policy may be equally capable of influenc-ing domestic monetary conditions in the medium to longrun as via discount rate or open market operations.However, these policy instruments would be less wellequipped for day-to-day control for two reasons. First,response lags must inevitably be permitted before insist-ing on compliance. Second, coercion or moral suasion asopposed to price incentives cannot be applied too fre-quently or the system of control would be placed underexcessive strain.

Another factor is that the attainment of monetary tar-gets consistent with a country's development plan mayrequire more policy intervention than the manipulationof interest rates or the direction of domestic credit. Forexample, there may be a fundamental incompatibilitybetween the deposit rates needed to generate the requiredsaving, the lending rates required to induce planned

investment, and the interest rate spread necessary forbank profitability. To escape such a situation, the mone-tary authorities may need to adopt an entrepreneurialrole in encouraging institutional innovation.8 Domesticsaving may be accelerated by setting up new financialinstitutions—such as credit unions, provident funds, andunit trusts—that offer attractive alternatives to the bankaccount and the hoarding of cash. Such institutions mayrequire subsidization in their early years, given the infra-structural economies of scale which deter private initia-tive. Private holding of government securities and com-mercial paper may be promoted by reducing restrictionson access and by market intervention designed to reduceprice fluctuations; both of these actions would enhancethe liquidity of these assets. On the credit side, lendingfor socially desirable investments may be increased byestablishing a development bank capable of thoroughproject assessment and the disbursement of interest ratesubsidies. Commercial lending to small-scale and ruralenterprises may be encouraged by providing credit guar-antees and legal safeguards that would reduce the costs ofdefault.

At the other extreme, some countries have adoptedsophisticated programs aimed at establishing their finan-cial sectors as international centers earning foreignexchange through the export of financial services. In suchsituations, the authorities' role must be directed towardachieving an appropriate balance between the policing ofwell-advertised standards of behavior that ensure confi-dence in the probity of the domestic institutions and flexi-bility in setting these standards so as to promote vigorousmarket responses to shifting external opportunities. Inmany such cases, a sharp distinction is drawn betweenthe onshore financial system, which trades in local cur-rency, and the offshore market, which is based on instru-ments denominated in an international currency. Unlessthis distinction is preserved by strict controls on trans-actions between the two sectors, domestic conditionswould tend to be dominated by the external financialenvironment.

The requirements of the lender of last resort and of thebank supervisor in small, developing countries willdepend on the prevailing financial structure and onambitions for reform. These functions will often beundertaken by parent banks to the extent that domesticbanks are foreign owned. Parent banks are likely tomonitor the branch's operations, to offer financial exper-tise, and to provide short-term credit to the branch in acrisis—and indeed will often be better equipped to fulfillthese functions than would the domestic authorities—inorder to maintain the parent bank's international reputa-tion for sound management. In such circumstances, thedomestic authorities would retain an important licensingfunction—the denial of entry to international banks that

7

8See Bhatt (1974).


III • THE ROLE OF CENTRAL BANKING IN DEVELOPING COUNTRIES

do not achieve high standards—but need be less con-cerned with supervising day-to-day operations. Neverthe-less, the supervision of foreign exchange, interest rate,and credit control regulations may be particularly neces-sary in order to guard against the possibility that the fewforeign branch banks might take undue advantage oftheir oligopolistic position in the domestic market.9

On the other hand, in other countries, active regula-tory and financial support would be essential if theauthorities sought to promote indigenous financial enter-prises as a primary objective. Local institutions would beinitially at a considerable competitive disadvantage inbeing unable to trade on a parent bank's reputation.Moreover, bank failure would have a particularly unde-sirable impact, not so much directly as interrelationsbetween banks may be small in scale, but rather througha strong detrimental effect on attitudes toward indige-nous financial institutions in general. Confidence in thedomestic financial system may be bolstered by the exis-tence of a lender of last resort and by provision of depositinsurance facilities. But these activities could be prohibi-tively costly without sufficiently close supervision of bankoperations to ensure prudent financial behavior. In a sit-uation with low standards of domestic accounting tech-niques and inadequacies of information, such supervisionwould require considerable commitment of central bankresources.

Social and Political Constraints on CentralBanking

One obvious constraint on the central banking institu-tion of a small, developing country is a shortage of indigenous personnel who have the training and experience toconduct its business. Often the former central bankinginstitution, such as, for example, a currency board, willhave carried out largely mechanical functions and haveprovided few opportunities for staff to develop opera-tional skills or financial acumen. The senior managers ofthe foreign-owned banks will tend to be expatriate and inlimited supply; they may well be reluctant to leave the pri-vate sector and, in any case, may be regarded with somesuspicion by the government. Foreign experts may beimported but may lack local knowledge and contacts,may be expensive to hire, 10 and would probably be unwill-ing to make a long-term commitment. Thus, a constraint

9A common feature of an unregulated oligopolistic banking structureis a form of financial repression in which banks choose to set depositinterest rates low, often implying negative real returns, and opt for aconservative lending policy. Such a strategy tends to lead to slow growthof financial intermediation, but to ensure steady profits.

10Limited numbers of experts may be supplied at subsidized costs bytechnical assistance programs run by, for example, the Central BankingDepartment of the International Monetary Fund.

on human resources may limit the extent to which the cen-tral banking institution can involve itself in certain activi-ties, particularly ones requiring both technical expertiseand intensity of application—such as banking supervisionand economic research to guide policy selection.

An equally important but more controversial issue isthe question of how to ensure that the central bankinginstitution plays an appropriate role in policy selection.The arguments used in Section II to support the indepen-dence of the central banking institution are, perhaps,particularly applicable in a developing country. ThirdWorld governments have often succumbed to the tempta-tion to use rapid monetary expansion to finance short-term gains that are dissipated in subsequent inflation (or,in extreme cases, hyperinflation). However, even ifdesired, it is difficult to guarantee the independence ofany central banking institution, and especially one in adeveloping country. This independence may have beenachieved in certain developed countries that have consti-tutionally enshrined the central bank's freedom of actionto seek specific objectives. These countries also usuallypossess established financial communities that wouldprovide firm support for policies aimed at the attainmentof monetary stability.

In developing countries, independence de jure maywell not be sufficient to ensure independence de facto.For one thing, the local financial community may beeither unable or unwilling to provide much assistance tobolster a central banking institution whose policy inten-tions conflicted with the government's wishes. Indige-nous financial institutions might be too poorly estab-lished or too closely related to the government by eitherpersonal ties or dependence on government favors.Foreign-owned banks, meanwhile, would be reluctant tobecome closely involved in domestic political issues.Without the support of a powerful ally, the central bank-ing institution may be susceptible to political influence. Ifthe executive board of the central banking institutiontried to resist the government's wishes, the governmentcould respond by using its powers of dismissal and appoint-ment to obtain a more sympathetic set of decision makers.These powers would be weakened if they were hedged bylegislation that lengthened terms of appointment and estab-lished proper judiciary procedures for dismissal. The gov-ernment might, nevertheless, be able to bring sufficientinformal pressure to bear to ensure that even a nominallyindependent central banking institution would set its policyin accordance with government wishes.

A variety of means has been used in the attempt to bol-ster the independence of monetary policy; indeed each ofthe four basic alternatives to the central bank to be dis-cussed in Sections IV-VII employs a distinctive approachto this problem. Essentially, however, these differentmethods are all permutations on two basic devices. Thefirst is to include directions to or constraints on policyselection in the legislation establishing the central bank-

8


Social and Political Constraints on Central Banking

ing institution, with the intention that the setting of limitson the discretionary powers of the central banking insti-tution would also serve to reduce the ability of the govern-ment to impose its own will on monetary policy. Selectionof such an approach would presuppose a decision that theappropriate form of monetary policy would be largelynondiscretionary, and could only be successful if consti-tutional and other safeguards were sufficient to preventthe relaxation of the legal restrictions when convenient.

The second device is to transfer a measure of responsi-bility for monetary policy decisions to an external body,such as a central banking institution shared with othercountries or even belonging solely to another country,that would be able to resist home government pressuresmore successfully. Such an arrangement would typicallyinvolve joining a monetary union, which would place con-straints on monetary policy and require the acceptance offoreign involvement in domestic affairs.

9


IV The Transitional Central Banking Institution

The transitional central banking institution, as itsname implies, can be seen as a stepping stone in thetransformation of a country's monetary authorities froma colonial currency board to a full-fledged central bank.The typical currency board issued domestic currency forforeign exchange and offered limited banking facilities tocommercial banks. It did not have the power of fiduciaryissue; it did not conduct monetary policy or even providepolicy advice; it was not committed to acting as lender oflast resort; it did not supervise the banking system orimpose any prudential reserve requirements. Its basis layin a financial system dominated by commercial banksoriginating in the colonial power, which were expected tobe able to mind their own branches, and in a commit-ment to a fixed parity with the colonial power's currency,which implied a passive monetary policy. The primaryraison d'etre for the currency board lay in capturing theseigniorage benefits of currency issue for the colony itself.The external value of the currency was guaranteed by therequirement, implicit in the process of currency issue,that the currency be backed 100 percent by foreignexchange reserves.

In contrast, the transitional central banking institutiontypically conducts a wider range of activities than the cur-rency board, at least acting as banker to the governmentand to the central bank, and possesses greater powers,including those of fiduciary issue and often bank inspec-tion. Nevertheless, the functions it undertakes arerestricted to a narrower range than would be usual for acentral bank, and its operations are often subject to bothgovernment direction and legal restriction. These charac-teristics may be viewed as direct responses to the circum-stances in which the central banking institution mustfunction in a newly independent, small, developing country.

The transitional central banking institution econo-mizes its use of limited human resources by concentratingworkers in certain key functions to the neglect of others.The basic operational tasks of issuing currency, accept-ing deposits, making loans, and managing foreignexchange reserves may well absorb a high proportion ofthe technical expertise available. Unless promotion ofindigenous banks is a high priority for financial policy,commercial bank supervision provides a good candidatefor a relatively low level of involvement, being both skill

intensive and in part redundant if the banking system isdominated by foreign-owned banks.

Additional economies in manpower may be obtainedby confining responsibility for the analysis and formula-tion of monetary policy to the finance ministry, leavingthe central banking institution in charge of operationalmatters. The government would be granted an explicitright to override any decision of the central banking insti-tution, while policy coordination may be ensured by giv-ing the finance ministry representation on the monetaryauthority's board. This division of responsibility wouldbe feasible given the inevitable concentration of monetarypolicy on the medium rather than the short run; only rela-tively routine matters would need to be dealt with on aday-to-day basis.

A substantial degree of government control mightthreaten the credibility of the financial system, however, ifthe public were to believe that the government was likely tomisuse its influence over fiduciary issue. To bolster confi-dence, legal constraints are typically imposed on the oper-ations of the transitional central banking institution. Twosuch safeguards are commonly observed, usually in combi-nation: a foreign exchange reserve cover requirement anda limit on the central banking institution's holding of gov-ernment liabilities.

As mentioned above, the currency board was effec-tively required to hold 100 percent cover for domestic cur-rency issued. Transitional central banking institutionstend instead to be constrained to hold foreign exchangereserves to at least a certain percentage of their demandliabilities. This formulation reflects the role of the transi-tional central banking institution as a deposit-acceptinginstitution; in this role, reserve money does not only con-sist of currency issue but also includes bank deposits withthe monetary authority. Expressed in either form, therequirement imposes a legal limit on the fiduciary issue ofthe central banking institution.11 When the constraintbinds, the monetary authority may not increase domesticliquidity by extending domestic credit only but must, in

11 Whether a requirement that the central banking institution holdsay, 50 percent backing for its demand liabilities is more or less stringentthan a requirement that it hold 100 percent cover for currency issuedepends on the relative demand for currency and deposits in the econ-omy in question.

10


Fiji

addition, acquire foreign exchange. In practice, centralbanking institutions would normally aim to operatewithin the boundary to maintain flexibility in fiduciaryissue in the short term. It is also common for the centralbanking legislation to include a clause allowing tempo-rary relaxation of the rule with the finance minister's con-sent—although such a clause might partially circumventthe purpose of the constraint.

While the cover requirement clearly restricts the cen-tral banking institution's absolute ability to hold govern-ment liabilities, it does not prevent it from concentratinga high proportion of its assets into holdings of govern-ment debt. The cover requirement is typically supple-mented by two separate restrictions on such holdings,often imposed together. The first would limit the purposefor which advances to the government could be extendedto the finance of temporary deficiencies in currentbudgetary revenue; these loans must usually be repaidwithin a short period after the end of the financial year.The second would limit the central banking institution'soverall holding of government debt, including treasurybills and long-term securities as well as loans. This limitmay be expressed as a percentage of the government'sown average annual revenue over a preceding period or asa percentage of the central banking institution's totaldemand liabilities.

The most clear-cut examples of the transitional centralbanking institution are provided by a series of so-called"Monetary Authorities" set up over the last decade incountries which, with one exception, were formerly Brit-ish colonies: the Central Monetary Authority of Fiji(founded in 1973), the Solomon Islands MonetaryAuthority (1976), the Seychelles Monetary Authority(1976), the Monetary Authority of Belize (1978), the Mal-dives Monetary Authority (1981), and the Royal Mone-tary Authority of Bhutan (1982). In these cases, the title"Monetary Authority" was selected deliberately to sug-gest that the new institutions were not expected imme-diately either to carry out all the functions or to havethe operational independence of a full-fledged centralbank.12 In practice, many other central banking institu-tions in developing countries would be better categorizedas transitional central banking institutions than as cen-tral banks—despite being called "Central Banks."

A substantial uniformity in the legislation establishingthese transitional central banking institutions should notobscure a considerable diversity of behavior within thecategory. The legislation provides the transitional centralbanking institution with responsibilities and executivepowers which may be taken up only slowly; a spectrummay be observed from the one extreme of authorities thatfunction virtually as currency boards to the other of

12The title was first applied to the Monetary Authority of Singapore(see Section VII).

authorities that carry out most of the activities of the full-fledged central bank.

Fiji

The case of Fiji provides a good example of the gradualevolution of a transitional central banking institutionwithin a single basic legislative framework. The CentralMonetary Authority of Fiji (CMA) has been operating fora decade and over this period has accumulated consider-able reserves of technical expertise. It now conducts awide range of activities and is involved in most aspects ofthe financial system, which is itself relatively sophisti-cated relative to Fiji's small size and simple economicstructure. The economy is dominated by the performanceof the two major exports, sugar and tourism, and is com-paratively open to both trade and capital flows.

The CMA is endowed with the sole right of fiduciaryissue of the currency, the Fiji dollar, but is restricted bystatute to hold external reserves worth at least 50 percentof its demand liabilities and to seek the Minister ofFinance's approval for changes in parity. In practice, theCMA has held external reserves at least 100 percent inexcess of the statutory minimum, even in the seasonaltrough of low foreign exchange receipts, but this has notprevented foreign exchange reserves from falling at timesto low levels in terms of months of imports: the need for asustainable balance of payments rather than any statu-tory obligations has proven to be the dominant constrainton fiduciary issue. The CMA also exercises discretionover the rates of exchange for the Fiji dollar; these are seteach week to fix the Fiji dollar's value against a weightedbasket of currencies of trading partners. This systemreplaces the simple fixed sterling peg anticipated in thelegislation.

As banker to the government, the CMA is authorizedto grant advances to the government to meet temporarydeficiencies in currency revenue, subject to repaymentwithin the six months following the end of the fiscal year,and to hold securities and other debt instruments of thegovernment, provided that the total value of these doesnot exceed 30 percent of the average annual ordinaryrevenue of the government. In fact, the government hasbeen, for the most part, a net depositor with the CMA;total borrowing has never exceeded 50 percent of themaximum allowed. This observation remains true whenpublic sector corporations, which are also permitted tobank with the CMA, are included in the analysis. In thepast, the Fiji Sugar Corporation in particular, with itsstrongly seasonal pattern of receipts and expenditures,has made extensive use of this facility; but it is nowencouraged to deal directly with commercial banks.

Fiji's banking system consists of five foreign-ownedcommercial banks and the publicly owned National Bank.Banking legislation requires the former set of banks

11


IV • THE TRANSITIONAL CENTRAL BANKING INSTITUTION

to obey cash reserve and government security ratio require-ments set by the CMA and, in return, the CMA offerslender-of-last-resort facilities. These banks have usuallyamply exceeded reserve requirements, although the excessfulfillment has tended to fall over time as alternative usesfor funds have developed. In response, the CMA hasattempted to restrain the rising ratio of loans to depositsthrough moral suasion, but without complete success.Banks have taken only intermittent recourse to CMA lend-ing, preferring in general to borrow from the parent bankor on the expanding interbank money market. In additionto reserve requirements, banks must obey interest rate,credit allocation, and various other guidelines issued bythe CMA subject to government approval. The basis ofregulation lies in close liaison with the CMA in regularmeetings, rather than a formal inspection which is onlyauthorized at times of crisis.

In addition to the six commercial banks, Fiji possessesa unit trust, a stock exchange, a development bank, aninsurance industry, and a credit union movement. TheCMA is involved in the management and regulation ofthese in its efforts to promote the development of thefinancial system. Particular duties include the underwrit-ing of bonds issued by the development bank and thesupervision of the insurance industry, a function that hasbeen recently transferred from the Ministry of Finance.

Despite Fiji's openness, the CMA has been able to fol-low an active and independent monetary policy, using thevarious instruments at its disposal. In general, regulatedinterest rates have been kept low relative to world rates,although not so noticeably low relative to rates ruling inneighboring Australia and New Zealand. This policy issupported by limits on the domestic borrowing of foreignfirms and on outward capital flows. The overall strategyis guided by a monetary budget planning procedure inwhich the CMA has played an important part; its Gen-eral Manager currently acts as chairman of the mainpolicy-making committee while its Research Departmenthas been closely involved in forecasting exercises.

In sum, although the CMA still has the form of thetransitional central banking institution, its operationsare becoming sufficiently extensive and discretionary towarrant it the classification of central bank. At present,legislation is being considered to formalize this de factoindependence and to amend the original legislation whereappropriate. In particular, contemplated measures includethe transfer of responsibility for monetary policy decisionsfrom the government to the CMA to simplify cumbersomeadministrative machinery, the strengthening of powers of

bank inspection, and the inclusion of the National Bankunder the CMA's aegis.

Maldives and Bhutan

In the newest transitional central banking institutions,in Maldives and Bhutan, the authorities are still muchconcerned with establishing the national currency as thedominant form of money, a prerequisite to the practice ofan independent monetary policy. In Maldives, U.S. dol-lars—introduced into the economy through tourism—cir-culate alongside the local currency, the rufiyaa, whiletime and savings deposits and loans may be denominatedin either of the two currencies. The amount of dollars incirculation cannot be measured accurately, making it dif-ficult to monitor developments in domestic liquidity.Moreover, the possibility of dollar deposit and loanaccounts would complicate the application of any interestrate policy intended to separate domestic from worldrates. Recent policy, adopted after measures relying onvoluntary surrender had proved ineffective, has been toproscribe the use of dollars and other foreign currenciesas means of payments. In Bhutan, where the bulk of for-eign trade is conducted across an open border with India,the predominant currency in circulation is the Indianrupee, although all bank accounts and contracts aredenominated in the national currency, the ngultrum. TheRoyal Monetary Authority aims to administer a gradualincrease in the role of the ngultrum over time, so as not todisturb local confidence in its parity with the rupee.While this shift may be fairly simply accomplished in theinterior, the use of rupees seems likely to be more persis-

tent in border areas given the local importance of tradetransactions.

Among the first tasks of the authorities in both Mal-dives and Bhutan has been to assume responsibility forforeign exchange management from various governmentand other agencies. In Bhutan, matters are complicatedby the fact that the bulk of the country's net foreign assetsare held in rupee deposits by the country's single com-mercial bank, the Bank of Bhutan. The Bank of Bhutanis jointly owned by the Government and the State Bank ofIndia, which offers the Bank of Bhutan a preferentialreturn on rupee deposits. For the Royal MonetaryAuthority to fulfill the function of foreign exchange man-agement effectively, it must obtain satisfactory terms forits own rupee deposits, and be able to manage the busi-ness requirements of foreign exchange transactions.

12


V The Supranational Central Bank

This section discusses the supranational central bank,which may be characterized as carrying out all the func-tions of the central bank, but for a group of countriesjoined in monetary union rather than for a single countryalone. Such an institution would consist of a centralheadquarters, in which broad policy decisions would betaken, and separate agencies in each country undertak-ing operational tasks. Each member country would havean equal but limited role in influencing overall policy, buta stronger influence over operations with mainly domes-tic significance.

The characteristic features of a monetary unioninclude: (1) a common currency (or at least a set of freelyinterconvertible currencies); (2) compatible externalexchange restrictions; (3) minimal constraints on internalcapital mobility; and (4) a coordinating institution hold-ing a common set of exchange reserves. The usual "opti-mal currency area" rationale for the formation of amonetary union runs in terms of the advantages to begained from the improvement of the intraregional alloca-tion of resources, as exchange risk is eliminated (or atleast reduced) and internal barriers to the flow of fundsare removed, and from the reduction of the overall needfor foreign exchange reserves, as balance of paymentsrisks are pooled and intraregional transactions are con-ducted in a regional currency. On the other hand, mem-bership of a monetary union requires that national mone-tary policies be subordinate to the common regionalpolicy. National sovereignty is lost in the formulation ofpolicy on domestic credit expansion, interest rates, andexchange restrictions.13

In a developing country, however, two additionaladvantages may be obtained by joining a monetary unionand ceding sovereignty over monetary policy to a regionalcentral bank. First, the centralization of the centralbanking functions of many countries within a single unitleads to organizational economies of scale and reducesthe demands made on each country's human resources.Second, giving the supranational central bank responsi-bility for the overall direction of national monetary pol-icy, and, in particular, for setting national limits oncredit expansion, lowers the danger that a government

13See the discussion in Nsouli (1981).

would have a pernicious influence on policy formulation.Admittedly, the necessity of uniform regional interestrates might still be a drawback to such an arrangement.The costs attached to this uniformity would depend onthe disparities existing between the economic situationsin the different member countries of the union.

Three examples of monetary unions with suprana-tional central banking institutions, drawn from Africaand the Caribbean, are discussed in this section. All threearrangements originated in colonial monetary integra-tion, but central banking activities have been greatlyextended since independence, particularly in the Africancases. In the Caribbean example, the supranationalauthority still bears many features of the transitional cen-tral banking institution.

The West African Monetary Union andthe Central African Monetary Area

The West African Monetary Union and the CentralAfrican Monetary Area are the two standard examples ofmonetary unions with regional central banks. Their con-stituent countries were formerly French colonies partici-pating in the Franc Zone with the local currency, theCFA franc, being issued by two regional instituts d'emis-sion.14 Following independence, these countries chose toremain within the Franc Zone but, at the same time, tobroaden the regional institutional framework. Theyestablished supranational central banks, which were pro-vided with substantial autonomous powers although stillsubject to French influence. Local control was strength-ened further in reforms of both systems in the early1970s.

The West African Monetary Union (WAMU) is nowformed by Benin, Ivory Coast, Niger, Senegal, Togo, andUpper Volta. The Union continues to use the CFA francas the common currency and sets no controls on capitalmobility within the Franc Zone; each country imposes itsown particular exchange and trade restrictions. Thesupranational central bank, the Banque Centrale des

14The institut d'emission in a French colony served the same basic roleas the currency board in a British one.

13


V • THE SUPRANATIONAL CENTRAL BANK

Etats de l'Afrique de l'Ouest (BCEAO), has headquar-ters in Senegal and agencies in each country. The head-quarters is responsible for the formulation of policy andthe management of the common pool of foreign exchangereserves; the agencies conduct local operations. Eachcountry also has a National Credit Committee and is rep-resented on the Council of Ministers which oversees thesystem and bears primary responsibility for membershipand managerial appointments.

CFA francs are issued on demand by the agencies ofthe BCEAO, at a fixed parity with the French franc guar-anteed by the French Treasury. In return for this guaran-tee, the BCEAO holds an operations account with theFrench Treasury and must deposit at least 65 percent ofits nonoperational reserves with the Treasury; the Frenchprovide compensation to the BCEAO for any decline inthe value of these reserves against a chosen index—cur-rently the special drawing right. The BCEAO undertakesto replenish the operations account when necessary fromits non-franc reserve holdings, and to raise domesticrediscount rates and reduce rediscount ceilings shouldthe average value of net foreign assets fall below 20 per-cent of the BCEAO's demand liabilities for three consec-utive months.

The BCEAO acts as banker to each of the member gov-ernments, subject to the restriction that total gross creditto any government must be less than 20 percent of its taxreceipts in the previous year. Credit to the governmentmay take the form of short-term advances, holding oflong-term securities, and the rediscounting of commer-cial bank credit to government: all three are subject to thesame overall credit limit.

The dominant feature of the BCEAO's relations withcommercial banks is its refinancing of commercial bankcredit. Refinancing is provided, at the authorities' discre-tion, for up to 35 percent of a bank's total credit; a pref-erential rate is available for lending to agriculture, small-scale construction, and small to medium-sized locallyowned businesses. The BCEAO also organizes an inter-bank money market which provides a mechanism for thetransfer of funds between banks and between countrieswithin the WAMU. Commercial banks hold depositswith the BCEAO, but do not face specific reserve require-ments although foreign deposits are limited to workingdeposits. Banking regulations are uniform in all coun-tries except Senegal, and adherence to the regulations issupervised by the BCEAO.

Monetary policy in the WAMU is determined jointly bythe BCEAO and the National Credit Committees. Acredit budget is formulated for each country, taking intoaccount national and regional considerations, with theBCEAO bearing responsibility for the national credit tar-gets and the National Credit Committees having respon-sibility for the allocation of credit between different useswithin the national limit. The main instruments availableto the BCEAO to execute the resulting plan are its control

over commercial bank refinancing and the setting of theinterest rates in the money market. In the past, theseinstruments have not proven sufficient to prevent overrunof targets, and recently they have been augmented bydirect ceilings on commercial bank lending. Bankdeposit and lending rates can only be altered with theapproval of the Council of Ministers and are adjustedinfrequently to prevent the emergence of excessive differ-entials between rates ruling in WAMU and elsewhere inthe Franc Zone.

Monetary arrangements in the Central African Monetary Area (CAMA)—consisting of Cameroon, the CentralAfrican Republic, Chad, Congo, and Gabon—are for-mally similar to those in the WAMU. The main sub-stantive contrasts lie in the greater degree of nationalsovereignty exercised within the CAMA, and the corre-spondingly more subordinate role played by its centralbank, the Banque des Etats de l'Afrique Centrale(BEAC). For example, banking legislation differsbetween each member of the CAMA and is enforced bynational bodies rather than the BEAC, while deposit andlending rates are not set uniformly. Control over refi-nancing is the main instrument of monetary policy-there is as yet no interbank money market—but creditceilings are applied flexibly. Overall targets are estab-lished by the National Monetary Committees, rather thanby the BEAC, while no constraints are applied to the refi-nancing of agricultural loans and export credits. Essen-tially, credit policy has accommodated demand and hasbeen sustained by the region's strong oil-based balance ofpayments position.

East Caribbean Currency Authority

The East Caribbean Currency Authority (ECCA) wasset up in 1965 following the dissolution of the British Car-ibbean Currency Board. Its seven member countries—Antigua and Barbuda, Dominica, Grenada, Montserrat,St. Kitts-Nevis-Anguilla, St. Lucia, and St. Vincent andthe Grenadines—are small island economies.15 Thesecountries are also linked in the Caribbean Common Mar-ket and the Organization of East Caribbean States,which are intended to establish a uniform trade policyand promote regional development and integration.There are no controls on capital movements within theEast Caribbean area, but external policy, lying outsideECCA jurisdiction, is not fully coordinated: tariffs areuniform across countries in theory, but tend to be diversein practice due to national divergences in application;indirect taxes and foreign exchange purchase taxes varybetween countries; and exchange controls are enforcedwith differing degrees of strictness.

15The relatively large neighbor, Barbados, withdrew from the cur-rency agreement in 1974 to establish its own independent central bank.

14


East Caribbean Currency Authority

The principal functions of the ECCA have been theissue of the common currency, the East Caribbean dollar,and the management of the foreign exchange reserves.The East Caribbean dollar is at present pegged to theU.S. dollar; a change in parity requires the unanimousapproval of member governments. The ECCA convertsthe East Caribbean dollar into foreign exchange ondemand for the commercial banks and has no prior rightto foreign exchange earnings. It is required to maintainthe value of its foreign reserve cover to at least 60 percentof its demand liabilities and has generally operated with asubstantial reserve cushion.

The 60 percent cover requirement acts as an overallconstraint on ECCA lending to member governments. Inaddition, the ECCA's statutes restrict its holding of trea-sury bills issued by any member government to 10 percentof that government's estimated annual recurrent revenue,and its combined holding of other securities of membergovernments to 15 percent of the ECCA's demand liabili-ties. In practice, the ECCA estimates the total permittedavailability of loanable funds each year and allocates bor-rowing rights to each member government in proportion tothe government's estimated revenues. Not all membercountries draw down their full quotas, and the ECCA hasin the past retained leeway to extend additional temporarycredit to governments facing emergency conditions.

The banking system in the ECCA member countries isdominated by branches of foreign banks. The main ser-vice provided by the ECCA to the banking system lies inthe operation of a central clearing house for interbankpayments. Participating banks are required to hold aminimum balance of noninterest-bearing call depositswith the ECCA and may be granted short-term overdraftfacilities. The ECCA also accepts time deposits, payingrates of interest designed to induce banks to depositfunds with the ECCA rather than overseas. Althoughrates are slightly lower than available elsewhere and theECCA applies no minimum liquid reserve regulations,foreign branch banks are generally willing to earn good-will by placing deposits with the ECCA. The ECCA also

offers rediscounting facilities, but these have not beenutilized: commercial banks in each country have been liq-uid and are generally unwilling to extend local creditbeyond local deposit resources. Thus, political problemsthat might be triggered if savings in one member countryflowed into investment in another are avoided.

At present, the ECCA itself has no regulatory responsi-bilities or powers; it imposes neither reserve restrictionsnor controls on interest rates or credit allocation. Com-mercial banks do, however, receive directions from hostgovernments to hold deposits with the ministry of financeor to hold certain proportions of their deposit liabilities ingovernment paper; these requirements usually depend ongovernment financing needs rather than being designedto support any particular monetary policy. Foreign-owned banks are also subject to the dictates of their par-ent banks. In practice, these banks have opted for con-servative policies, with low (often negative, in real terms)deposit rates and relatively high interest spreads, whichhave led to moderate rates of growth of assets but secureprofits.

Given its limited array of powers, the ECCA has littlescope for the exercise of monetary policy. Its organizationcombines features of the transitional monetary authoritywith those of the supranational central bank to curtailgovernment's ability to sustain deficit finance. Govern-ments seeking funds in excess of the ECCA's lending tar-gets must face the discipline of external capital markets,while internal adjustment policies rely mainly on fiscalpolicy for stabilization purposes. The decision has nowbeen made to convert the ECCA into a central bank moreakin to the BCEAO and the BEAC. This new institutionis to be endowed with statutory rights to impose reserverequirements on commercial banks, to set interest rateminima and maxima, and to regulate the availability ofmoney and credit. The 60 percent foreign cover require-ment and government lending limitations are to remainin force, but the new provisions will permit relaxation ofthese limits with the unanimous approval of membergovernments.

15


VI The Central Banking Institution in a Currency Enclave

In a currency enclave, the currency of a typically largerand more developed foreign country circulates alongside,or in some cases in place of, the domestic issue. This situ-ation has arisen where extensive and unregulated tradewith a dominant partner, predating the establishment ofa national currency, has led to the customary acceptanceof the partner's currency as a means of transaction. Withsuch a high degree of financial openness, domestic inter-est rates and credit conditions in the enclave are stronglyinfluenced by monetary conditions in the partner. More-over, in this context, powers of fiduciary issue would beparticularly limited as the domestic currency (often con-fined to coinage) may have only restricted acceptability asa means of transaction. In addition, if local contracts aredenominated in the foreign currency, shifts in exchangerate parity do not alter relative prices. For all these rea-sons, the scope for independent monetary policy in a cur-rency enclave is particularly narrow, and the role of thedomestic central banking institution may be limited.

The influence of central banking in the enclave may bereinforced, however, by the actions of a monetary author-ity in the partner country. In particular, such an author-ity would be likely to have greater ability to extend emer-gency liquidity in a crisis. A cooperative arrangementcould be feasible if the interests of the two countries werelargely compatible and if the allocation of responsibilityto the partner were politically acceptable. Indeed, suchan arrangement might be preferred to the alternative ofextending the fiduciary powers of the currency enclavecentral banking institution on the grounds that an exter-nal agency would be less susceptible to undue internalpolitical pressures and have a more established record forfinancial competence and prudence.

The case studies in this section include two countries,Liberia and Panama, which rely on the U.S. dollar as theprincipal form of money—domestic issue being restrictedto coinage—but have no formal support agreement withthe U.S. authorities. By way of contrast, the second twoexamples of enclaves, the Rand Monetary Area andFrance d'outre-mer, have central banking institutionswhich are closely linked to authorities in the partner coun-tries. The earlier discussion of Bhutan and Maldives isalso relevant in this context in describing countries thatare making the transition from enclave to independentmonetary area.

Liberia and Panama

In Liberia and Panama, the U.S. dollar is legal tenderand the domestic issue of currency is confined to coinage.

In both of these countries, foreign-owned commercialbanks dominate the financial systems, which are open tounrestricted current and capital transactions.16 In Libe-ria, the central banking institution is the National Bank ofLiberia, which was established in 1974 to take over thecentral banking functions previously conducted by theBank of Monrovia (a subsidiary of Citibank)—includingthe provision of banking services to the commercial banksand to the government—and to initiate bank supervision.In Panama, central banking responsibilities are sharedbetween the National Banking Commission and theNational Bank of Panama. The former is in charge ofbank supervision and is concerned with the promotion ofPanama as an international financial center. The latter isa commercial bank, although in part publicly owned. Inaddition to its regular commercial banking activities, itacts as banker to other commercial banks and as the fiscalagent of the government. It also plays the role of develop-ment bank in undertaking higher-risk loans in the publicinterest, using aid receipts to subsidize interest charges.Both the National Banks of Liberia and Panama under-take to supply their respective financial systems with theU.S. dollar notes and local coinage required to meet thedomestic transactions demand for currency.

Despite the formal similarity in the monetary arrange-ments of these two countries, their individual experienceshave been very different. In Panama, an environment offinancial stability has fostered rapid growth of domesticdeposits, while the combination of political security, lib-eral banking legislation, and economic prosperity hashelped to establish the country as an important offshorebanking center. By contrast, in Liberia, the financial sys-tem has encountered serious difficulties in recent years,manifested in the contraction of the money supply andprivate credit and the failure of a major bank. Theseevents have coincided with a deterioration in the externalbalance as the Government has attempted to compensateweakness in the export sector by increased public sectoractivity.

In the present context, it is important to note that theLiberian authorities' limited powers of fiduciary issuehave not screened the financial system from externalstrains; rather, these strains have been revealed in anunusual fashion. Given the scarcity of foreign exchange,the National Bank of Liberia has not always been able tofulfill its function of supplying dollar currency on demand

16Foreign exchange restrictions were introduced in Liberia in April1980, in the aftermath of a change in the government, but were removedthe following month, after proving difficult to operate, partially ineffec-tive, and damaging to external confidence.

16


The Rand Monetary Area and France d'outre-mer

for internal transaction purposes; the limited supplyavailable to it from exporters, reserves, and external bor-rowing is mostly absorbed in payment for oil imports' andin external debt service. So commercial banks are nolonger necessarily able to withdraw excess reserves fromthe National Bank of Liberia in cash. While these banksmay receive some foreign exchange from client exporters,they are not able to draw unlimited amounts on parentbanks unwilling to increase their Liberian exposure.Moreover, the currency in circulation is regularly depletedby direct deposit overseas. In consequence, cash bears apremium value against Liberian bank deposits, whichencourages commercial banks to compete for currencyand offshore resources rather than for deposits and loans.Indeed, banks may sometimes be unwilling to make pri-vate loans that would require import finance or to cash oraccept as deposits checks drawn against other banks. Thissituation has led to an inefficient allocation of monetaryresources and high transactions costs.

The Rand Monetary Area andFrance d'outre-mer

The Rand Monetary Area—consisting of Lesotho,South Africa, and Swaziland—was set up in 1974. It isbased on the use of a common currency, the South Africanrand, and provides for free transfer of funds within thearea, compatible exchange restrictions on the transfer offunds outside the area, and the pooling of gold and foreignexchange reserves with the South African Reserve Bank.17

Both Lesotho and Swaziland have subsequently estab-lished autonomous monetary authorities of their own: theLesotho Monetary Authority (founded in 1980) and theCentral Bank of Swaziland (1974).18 Under bilateralagreements with South Africa, the Lesotho and the Swaziauthorities are empowered to issue their own currencies,the maloti and the lilangeni, respectively, both valued atpar with the rand, to circulate as legal tender within theirown borders. Their currency issue must, under the termsof these agreements, be completely covered by their hold-ings of rand currency, special interest-bearing depositswith the South African Reserve Bank, and marketablesecurities of the South African Government. The SouthAfrican Reserve Bank is given specific responsibility to actas lender of last resort in Lesotho and Swaziland throughthe temporary extension of credit to the Lesotho MonetaryAuthority and the Central Bank of Swaziland. So while

17Botswana was a founding member of the Rand Monetary Area, butsubsequently withdrew when setting up its Central Bank.

18The Central Bank of Swaziland was originally entitled the MonetaryAuthority of Swaziland. This institution's name was altered in 1979without substantial extension of its powers or responsibilities.

the local monetary authorities obtain seigniorage fromcurrency issue, responsibility for ensuring monetary sta-bility is shared with an extranational agency.

In other respects, the Lesotho Monetary Authority andthe Central Bank of Swaziland bear many similarities tothe transitional central banking institutions discussedearlier. In common with the monetary authorities in Mal-dives and Bhutan, both must be prudent but resourcefulin promoting the gradual replacement of the foreign issueby the domestic issue without threatening confidence inthe new means of transaction. The Lesotho MonetaryAuthority has, for example, maintained a noninterest-bearing rand deposit account with a commercial bank inSouth Africa, which in its turn is willing to exchange themaloti for the rand at par; this arrangement is designed toencourage banks and merchants in South African borderareas to do likewise, and so enhances the usefulness of themaloti. In both countries, the monetary authorities havetaken steps to centralize the management of foreignexchange reserves, but substantial holdings remain in thehands of the commercial banks (in Lesotho) and the gov-ernment (in Swaziland). In Lesotho, in particular, theGovernment has continued to hold the bulk of its depositswith local commercial banks rather than with the mone-tary authority; the Lesotho Monetary Authority has beenimportant, however, in raising funds for the Government,in acting as an intermediary with foreign banks, and in theplacement of treasury bills, as well as being a substantialpurchaser of government securities. In Swaziland, theGovernment has been a net creditor of the Central Bank ofSwaziland and of the commercial banks. In both coun-tries, the commercial banks, which are either govern-ment-owned or foreign-owned, make deposits with themonetary authorities which provide an important compo-nent to the centralization of foreign exchange holdings;recourse to lender-of-last-resort facilities and bank super-

vision are both limited. Interest rates necessarily followfluctuations in South African rates, and monetary policyis in general passive.

In France d'outre-mer, the ties between the externalauthority and the local monetary system are even closer.The Institut d'Emission in Paris takes direct responsibilityfor the monetary affairs of both the Departments (such asGuiana, Martinique, and Reunion) and the Territories(such as French Polynesia and New Caledonia). Each ofthese Departments and Territories has its own currency butparity with the French franc is guaranteed by the Institutd'Emission. The Institut d'Emission is particularly con-cerned with control of the volume and allocation of credit,which it achieves through its policy of rediscounting vialocal agencies to commercial banks at prices dependent onthe use of funds. The Institut d'Emission is itself subject tothe French Finance Ministry's supervision.

17


VII The Central Banking Institution in an Extremely OpenEconomy

This section considers central banking institutions incountries with market-oriented economies, open to bothtrade and capital flows. As discussed in Section III, it maybe very difficult in such countries to exert a strong influenceon domestic interest rates or credit conditions. Moreover,successful export-led growth depends on foreign confi-dence in the continuation of the liberal trade and paymentssystem and in the establishment of a stable monetary envi-ronment. To maintain such confidence, the central bank-ing institution must be financially prudent; it must holdreserves, or at least have access to credit, sufficient to covernormal fluctuations in demand for domestic currency, andaim to restrict its own extension of credit to the increase indemand for its own liabilities. To provide some guaranteeof such behavior, the central banking institution may bestatutorily bound by restrictions on its fiduciary issue andon its lending to government.

A common feature of economies open to trade and capi-tal flows is that the financial sector is an important focus ofgrowth, often being a major source of foreign exchangeearnings. As noted in Section III, success in this fieldrequires the central banking institution to play a carefullyjudged regulatory role, designed to enhance confidencewithout stifling initiative. This active role contrasts with themore passive conduct of monetary policy.

Examples of central banking institutions in an openeconomy are provided by Singapore, Hong Kong, Kuwait,Saudi Arabia, and the United Arab Emirates. In Singa-pore, the fiduciary powers of the central banking institu-tions have been deliberately restricted but the regulatorypowers of these institutions are extensive. In Hong Kong,the monetary authorities have limited powers and finan-cial success has been achieved through almost unfetteredentrepreneurship. Finally, in the oil exporting Gulfstates, the strong fiscal position has led to a shift in re-sponsibilities between the central banking institution andthe government.

Singapore and Hong Kong

Since gaining independence, Singapore has combinedan export-oriented development policy with fiscal conserva-

tism and a stable political environment. Barriers to tradeand to capital flows have been progressively removed; by1978 exchange controls had been completely dismantled.Singapore has grown into a major financial center, and isnow the largest external currency center in Asia. There aretwo main central banking institutions, the Board of Com-missioners of Currency and the Monetary Authority ofSingapore, set up in 1967 and 1970, respectively; proposedlegislation that would bring the former under the auspicesof the latter has yet to be enacted. The Board of Commis-sioners of Currency operates as a strict currency board,controlling the issue of the Singapore dollar subject to hold-ing at least 100 percent foreign exchange reserve cover. TheMonetary Authority of Singapore is responsible for thebulk of the central banking functions and has a wide rangeof supervisory and regulatory powers. Recently, however,the task of managing the country's foreign exchange port-folio has been transferred to a separate body, the SingaporeInvestment Corporation, which is intended to provide amore aggressive approach to foreign investment.

The monetary operations of the Monetary Authority ofSingapore consist largely of recycling funds deposited bythe Government into the commercial banking systemthrough the rediscounting of bills and open market opera-tions. In the past, the Monetary Authority of Singaporeattempted to influence domestic credit conditions in linewith macroeconomic policy objectives. This policy wasbolstered by regulations intended to keep domestic andoffshore markets distinct. Since 1975, domestic depositand lending rates have been freely determined in the mar-ket and have followed the Singapore interbank rate,which in turn has followed the Asian dollar rate and,hence, world financial conditions. The Monetary Author-ity of Singapore has, for the most part, kept the rediscountand the treasury bill rates in line with these market rates,recognizing that a policy aimed at setting independentinterest rates could not be sustained for long, given theready domestic access allowed to international capitalmarkets. After a period in which the Monetary Authorityof Singapore attempted to steer domestic monetary aggre-gates along a target path, the current policy seeks to stabi-lize the exchange value of the Singapore dollar. This strat-egy is believed to be a more effective means to control

18


Kuwait, Saudi Arabia, and the United Arab Emirates

inflation in a highly open economy, and is conductedthrough swap operations in the foreign exchange market.

The regulatory functions of the Monetary Authority ofSingapore are directed at the promotion of the Singaporefinancial system. Entry into this system is limited by tieredlicensing, which allows less than half of registered banksto conduct the full range of banking operations; otherbanks hold "restricted" or "offshore" licenses. The Mon-etary Authority of Singapore imposes a series of liquidityrequirements on banks and finance houses, issues direc-tives guiding their lending operations, and controls theirnonbanking activities. It has also been instrumental inencouraging the development and diversification of theAsian dollar market. Not only are offshore operationsreleased from liquidity requirements and eligible for con-siderable tax benefits, but, in addition, the MonetaryAuthority has been fully involved in setting up offshoremarkets for bonds, certificates of deposit, and commer-cial paper.

The experience of Singapore may be contrasted withthat of Hong Kong. The economy of Hong Kong is verysimilar to Singapore's, but the former's colonial adminis-tration has been much less involved in financial affairs.Indeed, in Hong Kong, currency issue is performed by thetwo foremost commercial banks, the Hong Kong andShanghai Bank and the Chartered Bank, which also act aslender of last resort, serve as banker to the government,and administer the interbank clearance mechanism. Therange of functions entrusted to public institutions is lim-ited and divided. The Commissioners of Banking and ofDeposit-Taking Companies undertake the licensing,supervision, and regulation of banks and deposit-takingcompanies, respectively. The Secretary for MonetaryAffairs takes responsibility for the management of officialassets and liabilities, for the issue of coinage, for foreignexchange operations, and for relations with internationalmonetary institutions.

Official monetary policy in Hong Kong was purelylaissez-faire until the financial crisis in 1978. This crisisfollowed excessively rapid credit creation by the bankingcartel, leading to a collapse in the value of the Hong Kongdollar. Since then, the Commissioner of Banking and theSecretary for Monetary Affairs together have attempted torestrain the growth of domestic credit. Their influence hasbeen exerted primarily through moral suasion thatencourages domestic interest rates to follow world levelsmore closely, in combination with closer supervision offinancial operations. Neither open market operations nordiscount rate manipulation are available in the absence ofeither government securities or central bank lending.

In Hong Kong, in strong contrast to Singapore, themonetary authorities have never been much involved inthe promotion of the financial system. Even so, the finan-cial development of Hong Kong has proceeded at a rapidpace. It is therefore interesting to observe the recent reor-ganization in Singapore, where the Monetary Authority is

to take a less prominent part in guiding the evolution ofthe financial system and in supervising foreign branchbanks.

Kuwait, Saudi Arabia, and the United ArabEmirates

The economies of Kuwait, Saudi Arabia, and theUnited Arab Emirates fall into a distinctly different cate-gory of open economy than those of Hong Kong or Singa-pore. They are dominated by exports of oil, which providethe countries with considerable world market power toinfluence their terms of trade. A basic feature of theirrapid development over the last decade has been the rap-idly increasing deployment of government oil revenuesinto domestic investment. Financial sectors have grownwith the accumulation of financial wealth and the risingrequirements for internal financial intermediation, andhave been encouraged by governments seeking focuses fordiversification. Access to world capital markets is effec-tively good: there are few restrictions on financial flows,while the substantial stocks of both financial assets and oilreserves imply that marginal shifts in net lending cannotmuch affect these countries' aggregate net worth orthreaten their credit rating.

Kuwait and the United Arab Emirates both have Cen-tral Banks; Saudi Arabia, a Monetary Agency. Thesemonetary authorities are legally entrusted with the issue ofcurrency, the roles of banker to commercial banks andgovernment, the regulation and promotion of the bankingsystem, and the execution of monetary policy.

Of these roles, banking regulation is crucial to thedevelopment of these countries as financial centers, espe-cially as all three countries are intent on local ownershipand management of their financial institutions. In theUnited Arab Emirates, the Central Bank has only recentlydisplaced a currency board, endowed with little regulatorypower, following a banking crisis arising from rapidfinancial expansion and speculation against the domesticcurrency. This new institution has applied a minimumrestriction on the capitalization of domestic commercialbanks, and has required banks to accumulate out of theirprofits a reserve fund, the value of which should be at least50 percent of capital. Commercial banks must provide theCentral Bank with extensive information on their opera-tions and establish proper auditing facilities. The govern-ment intends to establish a separate Credit Risk Bureaucharged with monitoring local lending to support thissupervision. Kuwait and Saudi Arabia have also takensteps to strengthen monitoring and enforcement proce-dures. A particular problem now being faced in all threecountries is set by the money changers, whose activitieshave extended beyond their eponymous role but have hith-erto been unregulated. The authorities are taking steps torestrict licensing, to limit the range of activities under-

19


VII • THE CENTRAL BANKING INSTITUTION IN AN EXTREMELY OPEN ECONOMY

taken, and to establish proper monitoring facilities; butwhether such controls can be effective in a traditionallyinformal business sector remains to be proven.

In all three countries, the role of banker to the govern-ment is relatively limited. Given the substantial budgetarysurpluses, governments have not required loans fromtheir bankers; rather, they must determine the allocationof their accumulated financial resources between centralbank deposits and other uses. In the United Arab Emir-ates, deposits with the monetary authority claimed a par-ticularly small percentage of government assets in thepast, although this proportion has now risen to around 50percent following the establishment of the Central Bank,as the individual emirates hold considerable foreign assetson their own account. In Saudi Arabia, government finan-cial resources are recycled into the domestic economy viathe five government-owned, specialized credit institutionswhich provide long-term credit to priority sectors at highlyconcessional rates; the amount of this credit is, in fact,about double the total of commercial bank funds madeavailable to the private sector. The Saudi Arabian Mone-tary Agency itself receives government deposits intendedfor investment abroad. In Kuwait, government fundsreach the domestic economy at concessional rates both viathree specialized banks and via the combined intermedia-tion of the Central Bank of Kuwait and commercialbanks—the Central Bank provides cheap rediscountingfacilities to subsidize commercial bank lending, and isitself financed by government deposits and subsidies.

In these countries, monetary policy has attempted toinfluence domestic financial conditions. The CentralBank of Kuwait is empowered to limit the lending rates ofdomestic banks and has imposed low ceilings relative tothose rates obtaining elsewhere and to uncontrolled

deposit rates. This action is consistent with Islamic law,which prohibits interest payments, and also reflects adesire to encourage local investment. Narrow, even nega-tive, spreads between savings, deposit, and lending ratesare feasible for commercial banks receiving a high propor-tion of deposits as noninterest-bearing demand depositsand having access to low-cost central bank credit. SaudiArabia and the United Arab Emirates both impose ceil-ings on some deposit rates of interest. Given the minimalcontrols on capital mobility, these policies have leddomestic wealth holders to invest a substantial portion oftheir portfolios offshore, as well as in foreign currency-denominated deposits with domestic banks bearing inter-nationally competitive returns. In consequence, domesticmonetary aggregates do not fully reflect the total moneybalances held by residents.

An implication of these arrangements is that the gov-ernments of these countries have more influence ondomestic credit conditions than do the monetary authori-ties. It is up to the government to decide how much todeposit with the monetary authorities and the extent ofcredit subsidies; these decisions determine how far themonetary authorities and other specialized institutionscan expand domestic credit and at what price. In addi-tion, the government domestic budget deficit, that is, gov-ernment revenue from domestic sources less governmentdomestic expenditure, is the main source of increase inprivately held wealth.19 To the extent that this wealth isplaced in domestic bank deposits rather than being spenton imports or deposited abroad, it provides the commer-cial banks with funds to expand their own credit.

9See Morgan (1979).

20


VIII Conclusion

This paper has discussed the operations of a wide rangeof central banking institutions in developing countries. Ithas been observed that the public responsibilities andexecutive powers of these central banking institutions areoften less extensive than those normally associated with acentral bank in a developed country, although develop-ment priorities may lead to the acquisition of special func-tions not found elsewhere. A variety of reasons have beensuggested to explain why not all countries have full-fledged central banks. The three central points were:

Close integration of the domestic economy with inter-national commodity and capital markets may restrictboth the scope and the need for an independent mon-etary policy.

The domestic financial structure may not be suffi-ciently elaborate to support or require the full rangeof central banking functions, but may justify specialemphasis on particular regulatory and promotionalactivities.

The attempt to ensure a degree of independence ofmonetary policy from domestic political control mayinvolve legal constraints on central banking powersor the transfer of certain responsibilities to externalagencies.

The considerable diversity of economic, financial, andpolitical conditions within the Third World has broughtforth a wide variety of central banking institutions. Fourpolar types have been identified as providing coherentalternatives to the central bank. The transitional centralbanking institution forms an intermediate step betweencurrency board and central bank. Government typicallyexerts a strong influence on the activities of the transi-tional central banking institution, but this influence ischecked by statutory limitations on the monetary author-ity's discretionary powers. The supranational centralbank is responsible for undertaking the central bankingactivities in a group of countries participating in a mone-tary union. The framework of joint decision takingrestricts any individual government's influence over mon-etary policy. In a currency enclave, central banking activi-ties may be shared between the domestic central bankinginstitution of the developing country and a monetaryauthority of the larger partner. Monetary policy in the

enclave is limited by the dominating influence of the mon-etary environment of the partner and by the discretionarypowers allocated to the latter's authorities. Finally, in aneconomy open to both commodity and capital flows, themonetary environment is subject to the dominating influ-ence of world markets, and the central banking institutionis usually closely involved in the regulation and promotionof the domestic financial structure.

Table 1 summarizes the characteristic features of thesefour categories and of the currency board and the centralbank by assessing each for (1) its involvement in the sixcentral banking functions (the five discussed in Section IIplus the promotion of financial development) and (2) theconstraints placed on independence of policy selectionand execution. It should be apparent from the survey ofcountry experience provided in this paper, however, thatthe actual diversity of central banking institutions is notfully captured by this classification, and that, in practice,a monetary authority often displays characteristics com-bining features of more than one of the proposed polartypes.

In the end, it may be asked how much the choice ofcentral banking institution really matters. It could beargued that what counts in the final analysis is the balanceof political power between the government and monetaryauthority. On this view, the important factors influencingpolicy decisions would include the personalities of politi-cians and senior officials, and the support each groupcould draw from other sources; while the legal and organi-zational framework within which decisions are madewould be largely irrelevant.

Historical experience certainly indicates that legislationon its own may not be enough to guarantee prudent behav-ior. While many countries' central banking institutionshave not yet come close to violating foreign exchange coverrequirements or restrictions on government lending, inother cases the rules have simply been sidestepped bytechnical adjustments, altered expediently, or merelyignored. The question arises as to whether such rules areactually enforceable, especially when expressed in a flexi-ble and imprecise form. It seems likely that the prospect ofa foreign exchange crisis would act as a more powerfuldeterrent to financial profligacy, and that the ultimatediscipline to monetary policy would lie in external limits

21


on borrowing from world financial markets. Nevertheless,rules do have symbolic importance in establishing confi-dence in the new monetary order in the early stages of atransition, and especially if the transition involves theintroduction of a new national currency. Conversely, thedeletion of apparently inoperative constraints on fiduciaryissue or lending to government might create expectationsthat the authorities did in fact intend to violate their con-ditions. Even if the rules in force served no immediatepurpose, their removal could still have an undesirabledestabilizing effect on the system.

The organizational structure established by legislationprobably plays a more positive part in determining a cen-tral banking institution's characteristic behavior. Operat-ing procedures, channels of communication, and lines ofcommand all exert some influence on where and how deci-sions are made in practice. Seemingly mundane matters,such as rights of access for consultation and powers of

appointment, may ultimately be more relevant than themore grandiose objectives and powers enshrined in thecentral banking legislation. The balance of powerbetween government and monetary authority does notonly depend on personality and outside support but willalso be influenced by the institutional framework in whichtheir interaction is established. Otherwise, much lessattention would be devoted to the design of central bank-ing institutions than has been throughout the world—from Bhutan, now setting up its very first monetaryauthority, to the United States, where relations betweenthe Federal Reserve Board and the Executive have beenthe subject of continuing debate. While limits may exist towhat can be achieved by statutory means, the existence ofsuch limits merely underlines the need for care and atten-tion to the legislative and organizational form of centralbanking institutions.

22

VIII • CONCLUSION

Table 1. Alternative Central Banking InstitutionsFunction

Regulation Operation PromotionBanker to of of of

Currency Banker to commercial financial monetary financialInstitution issue government banks institutions policy development

Full-fledged central bank 3 3 3 3 3G 1Supranational central bank 3E 2E 2 2 2E 2Open economy central

banking institution 3C 2C 2 3 1 3

Transitional centralbanking institution 3CG 2C 2 1 2G 3

Currency enclave centralbanking institution 1,2CE 2CE 2 1 1 3

Currency board 3C 1 1 1 1 1

Key: 1 = limited involvement C = considerable constitutional restrictions2 = substantial involvement E = considerable external influence3 = full involvement G = considerable government influence


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Occasional Papers of the International Monetary Fund(Continued from inside front cover)

22. Interest Rate Policies in Developing Countries, by the Research Department of the InternationalMonetary Fund. 1983.

23. International Capital Markets: Developments and Prospects, 1983, by Richard Williams, PeterKeller, John Lipsky, and Donald Mathieson. 1983.

24. Government Employment and Pay: Some International Comparisons, by Peter S. Heller andAlan A. Tait. 1983. Revised 1984.

25. Recent Multilateral Debt Restructurings with Official and Bank Creditors, by a Staff TeamHeaded by E. Brau and R.C. Williams, with P.M. Keller and M. Nowak. 1983.

26. The Fund, Commercial Banks, and Member Countries, by Paul Mentre. 1984.


International Monetary Fund, Washington, D.C. 20431, U.S.A.Telephone number 202 473 7430

Cable address: Interfund


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