Current Developments in Monetary and Financial Law, Vol. 2

Chapter 16 Central Banks and International Financial Volatility

International Monetary Fund
Published Date:
October 2003
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In November 1990, the Central Banking Department of the IMF. now the Monetary and Exchange Affairs Department (MAE), held a seminar on the evolving role of central banks in the light of the economic events occurring in the world at that time. The focus of the seminar was on the transition to a market economy in the countries of Eastern Europe and the prolonged period of high inflation affecting many developing countries (see Downes and Vaez-Zadeh, 1991). The seminar was attended by central bankers from various regions, IMF officials, and members of its Executive Board. Interest focused on the role of central banks in the development of the financial system, their responsibility in clearing and payment systems performance, and the importance of limiting government financing. Discussions also dealt with the relationship between monetary and exchange rate policies, between monetary policy and the prudential supervision of the financial system, and the implications for monetary policy of the losses accumulated by central banks. Special importance was attached to the examination of the appropriate degree of central bank independence, and to the issues relating to the role of central banks in financial reforms and economic transition. Finally, consideration was given to the role of central banks in financial crises.

However, unexpected trends occurred throughout the 1990s, in particular the increased volatility of international financial markets—brought about by the sudden stops and reversals of external capital flows and the intensification of financial crises—giving rise to significant losses in the output and wealth of numerous countries. As a result, today central banks' agendas have incorporated issues that are relevant in the context of the new international environment. There is a renewed debate about the appropriate exchange regime that countries should adopt, with opinions mostly divided between those who favor the adoption of exchange systems based on currency board arrangements or systems based on the U.S. dollar (or another strong currency as legal tender), and those that prefer a flexible regime supported by an “inflation targeting” scheme. Another issue of discussion is the level of involvement and the role of central banks in banking crises resolution, given the adverse effects of such participation on monetary policy and the central bank’s financial position. Finally, central banks are increasingly concerned about achieving greater levels of transparency and accountability in order to help strengthen monetary policy credibility and effectiveness.

The aim of this paper is twofold. First, it reviews the functions of modern central banking in the context of the autonomy granted to these institutions in a number of countries during the last decade. And, second, it examines some critical issues that are currently part of the agenda of central banks in a world of high volatility of external financial markets and frequent domestic banking crises. As a starting point, the following section reviews “best practices” in the design of central bank autonomy given the broad consensus that prevails today around this institutional reform. In the next section, a brief overview of the main functions assigned to autonomous central banks is provided. The final section is the core of the document and examines the main challenges facing central banks in an environment of increased international financial instability, banking crises, and contagion.

Modern Central Banks and Autonomy Reform

Today, the legal and economic framework governing central banks provides a wide-ranging autonomy to these institutions.1 A large number of countries during the 1990s embraced the autonomy reform with the aim of providing monetary authorities with the instruments necessary to fight inflation. From a broader perspective, the autonomy of central banks was one of the components of the structural reform, and in particular, of the financial reform adopted in various countries as part of the dominant trend of stimulating a better functioning of market economies.

There is no single definition of the term independence applied to central banks. Broadly speaking, it may be understood as a legal and institutional arrangement that allows monetary authorities to adopt policy decisions and operational procedures aimed at achieving and preserving price stability apart from the government and private sector’s interests. Grilli et al. (1991) distinguishes between political and economic independence. Political independence refers to the capacity granted to the central bank to select policy objectives without government interference. In contrast, economic independence relates to the legal basis that supports the central bank in the unrestricted use of monetary policy instruments, and this independence is determined by the limits on the government’s access to central bank credit. Fisher and Debelle (1994) draw a similar distinction in terms of goal independence and instruments independence. The former relates to the central bank’s authority to freely determine policy targets (i.e., inflation) while the latter refers to the central bank freedom to use all instruments necessary to achieve a given target, which is defined by—or in agreement with—a political authority.

Rationale for Central Bank Autonomy

The increasing trend toward having independent central banks is based on the criterion that inflation imposes high costs on society, which are measured in terms of lower economic growth2 The theoretical underpinnings of this reform are related to the history of the Phillips curve and the associated academic debate, which has led to the increasing consensus around the idea that, although money is neutral in the long run (i.e., there is no trade-off between output and inflation), it can affect growth and employment in the short run. As a result, a central bank that is dependent on a political authority could engage in practices of “dynamic inconsistency” giving rise to an “inflationary bias.”3 In contrast, an autonomous central bank that does not produce unexpected inflation (say, for reasons of reducing unemployment or financing the fiscal deficit) may well enjoy credibility regarding its commitment to price stability.

From a theoretical view, the independent central bank model has been discussed in the literature according to two different approaches. The first is that of the so-called conservative central banker proposed by Rogoff (1985), whereby society delegates the conduct of monetary policy to a person who assigns a more severe evaluation to the welfare costs generated by inflation than society’s assessment. The second approach goes beyond the delegation arrangement and models an explicit contract between society and the central banker (Walsh, 1993), whereby inflation targets are negotiated with the government, such that the central banker’s wage is negatively affected if the increase in prices deviates significantly from the negotiated target. The approach adopted in practice by most countries is based on the delegation model, with New Zealand being the closest example to the explicit contract approach.

Empirically, most studies show that in the case of industrial countries there is a negative correlation between central bank independence and inflation, although there is no evidence of causality. The index commonly used to measure central bank independence involves legal and institutional aspects associated with the central bank objective, the procedures used to appoint central bank governors, and the financial links between the central bank and the government (see Grilli et al., 1991; Alesina and Summers, 1993). At the level of developing countries, such negative correlation is not observed (Cukierman, 1992) unless a distinction is made between de jure independence and de facto independence. The latter is expressed in terms of the frequency of turnover of central bank governors as a proxy variable, and assuming that its greater stability is a measure of a greater central bank autonomy (Cukierman et al., 1992). If the sample is restricted to the economies in transition, Loungani and Sheets (1997) find a negative correlation between increasing autonomy of central banks and lower inflation. In turn, Lybeck (1999) obtains the same result for the former Soviet Union countries, incorporating a public accountability component into the indicator of central bank independence.

Although the majority of opinions favor the institutional strengthening of central banks aimed at ensuring price stability, some views attach less importance to this relationship. Posen (1994) argues that the political decision to fight inflation and the adverse sentiment of the banking system toward inflation is more important, insofar as the costs exceeds its benefits in an inflationary environment. Mas (1995) questions the efficiency in the selection of central bank directors, which he claims does not necessarily result in conservative central bankers—his belief being that since fiscal policy is the main source of inflation, it is in this area that corrective measures must be taken. In a similar vein, Worrel (2000) attaches priority to the coordination of monetary and fiscal policies, particularly in small open economies, as a more efficient tool to defeat inflation, while others, including Forder (1998) see the potential limitations to credibility in the policy announcements made by the central bank. A popular critique is provided by Stiglitz, who approaches the problem from a democratic philosophy perspective, asserting that “there is a rationale for a degree of independence of the central bank, even in a democratic society. But the central bank must be accountable, and sensitive, to democratic processes.” He proposes that “there must be more democracy in the manner in which the decision makers are chosen and more representativeness in the governance structure” (see Stiglitz, 1998). Empirically, Posen (1995) questions the negative correlation between central bank independence and inflation in industrial countries, when the sample period is extended to 1950–1989. A study of the IMF (1996) also finds that the negative correlation between inflation and increasing central bank independence, although valid for industrial countries, may be subject to changes depending on the sample period defined for the analysis.

Main Components of the Autonomy Reform

After several years of experience with the central bank autonomy reform in a number of countries, the IMF’s MAE Department has drawn lessons, which have been used in providing technical assistance to member countries interested in reforming central bank laws (see IMF, 1998). The main components of the recommendations provided by the IMF can be grouped in four major categories: first, the definition of objectives and targets for the central bank; second, the modality of political autonomy; third, central bank economic and financial autonomy; and, fourth, the need for public accountability as a counterpart to the autonomy granted. These four recommendations are summarized in Table 1 and discussed hereafter.

Table 1.Main Recommendations for the Central Bank Autonomy Reform
Principal CriteriaMain Guidelines
Clarity of objectivesEstablish a primary objective, namely, to preserve price stability. In the case of more than one objective (for example, price stability vs. stability of the financial system), the first should prevail where disputes arise. A specific target—for instance, a given rate of inflation—should be defined and disclosed to allow better monitoring and accountability.
Political autonomyMost countries give central banks instrument independence. Members of the central bank’s board of directors should be nominated and appointed by the executive branch and parliament in a dual process, without government and private sector direct representation. Terms of office should be longer than that of the executive branch, while grounds for dismissal of board members should be strictly legal in nature and clearly established, avoiding any political interference.
Economic and financial autonomyProhibition or limitation of credit to the government should be established and disclosed. While the exchange regime should be defined by the government or agreed upon with the central bank, the execution of the exchange rate policy should be solely a central bank responsibility. Rules must clearly state the relations and functions between the central bank and the government, including the treatment of central bank losses/profits and the maintenance of central bank capital on the part of the government.
AccountabilityCentral banks must be held accountable and their governors should appear periodically before a designated political authority (Congress) to report on the conduct of monetary policy and the achievement of policy objectives. The report must be widely disseminated and explained. Financial statements must be published at least once a year under international accounting standards while summarized versions must be published more frequently.
Source: IMF (1998).
Source: IMF (1998).

The conventional wisdom favors central banks assigned with the primary objective of preserving price stability, based on the criteria that inflation is a monetary phenomenon and therefore falls within the natural scope of action of central banks. This is considered the best contribution that central banks can provide to the superior goal of improving living standards, given that price stability is considered a necessary, although not sufficient, condition for achieving a sustainable economic growth. On the other hand, assigning priority to price stability, or having it as a single objective, facilitates the definition and monitoring of targets and holds the central bank accountable, thereby enhancing the credibility and effectiveness of monetary policy. An example of a clear mandate is that of the European Central Bank, which states that “the primary objective of the European System of Central Banks shall be to maintain price stability.” In the event the central bank is assigned multiple objectives—for example, price stability and the stability of the financial system, which may conflict with one another in the short term—a conflict resolution mechanism should be established and disclosed.

Regarding political autonomy, it is recommended that central banks should have operational or instrument independence rather than goal independence. This implies that the central bank must design and execute interest rate policy and, in general, have the freedom to use all monetary instruments that are required to achieve the inflation target, while inflation is defined by the government or is mutually agreed upon with the central bank.4 Should the government have the right to overrule a decision adopted by the central bank, there should be a disclosed mechanism of conflict resolution. In addition, the members of the central bank board should be nominated and appointed respectively by both the Executive Branch and Parliament in a dual process to reinforce political independence. They must not represent the government or the corporate private sector in order to avoid conflicts of interest, for example, in relation to interest rate policy.5 Moreover, their nomination and appointment should be staggered over time, to limit the link between the central bank board and the government. Equally important, the grounds for dismissing directors must be strictly legal in nature and clearly stipulated by law in order to reduce the central bank’s political vulnerability, while the process of dismissal should be overseen by the Judicial Branch.

Economic autonomy must be based on the prohibition or a severe legal limitation on the central bank for providing the government with financing, since this has been the recurrent cause of inflation in various countries. Regardless of who defines the exchange regime—the government, the central bank, or both in agreement—the central bank should have independence to conduct exchange rate policy, given its strong link with monetary policy. Financial autonomy implies that the central bank’s solvency is legally guaranteed and maintained, so that if capital shortfalls occur, the government must be obliged to restore them.6 This is because the persistent accumulation of central bank losses restricts monetary operations and limits the central bank’s ability to comply with its fundamental objective of preserving price stability. The counterpart to this mandate is that the central bank must transfer its annual profits to the government budget once the required provisioning for legal reserves has been completed.

Accountability is the other side of the coin to the autonomy granted to the central bank. Although accountability is usually prescribed in central bank laws, the modality for executing it is often vague. As a result, a marked imbalance results between accountability and autonomy in favor of the latter. The modern trend points to central banks presenting open public reports on their operations before the Parliament (or a designated commission within the legislature). The report should include an assessment of the achievement of the policy target announced for a relevant period, and the policies and actions adopted to reach this target. When inflation is the target, “escape clauses” or measures of “core inflation” should be used and explained to the public in order to evaluate correctly central bank efforts, in particular, when the economy is vulnerable to adverse external shocks. In addition, central banks must publish their financial statements audited by an independent firm or authority at least once a year, and summarized versions of this information should be published on a more frequent basis. Accounting and disclosure of central bank transactions and financial statements should follow international standards.

Toward the Consolidation of Central Bank Autonomy

Notwithstanding the success in reducing inflation in most countries during the past years, the central bank autonomy reform is still in the process of consolidation. This consolidation depends largely on future central bank ability to preserve and maintain price stability, so that markets can rely on an autonomous institution with sufficient reputation to guide expectations about long-term stability and economic prosperity free of political cycle disruptions. However, it is also important that reduction in inflation should be accompanied by long-term economic growth that is sufficiently high and sustainable to help improve the overall standard of living. Although promoting growth is typically a government responsibility and, hence, does not fall within the scope of central bank objectives, a protracted period of low economic growth—which does not allow welfare improvement—may raise unjustifiable criticism against central banks, claiming that the anti-inflationary stance is restraining economic activity. At the extreme, some voices may even suggest the reversal of central bank autonomy, creating uncertainty and eventually an “inflationary bias.” Several Latin American countries just experienced adverse reactions against the central bank during the 1998–1999 recessionary period.

The history of a country’s inflation is also relevant for the purpose of consolidating the central bank’s autonomy reform. A country with a record of moderate inflation—where the society has become accustomed to living with a 15 to 30 percent rate per year—tends to voice little criticism of the accompanying social costs and to inappropriately identify the root of the inflation problem. As a result, the community, and in particular governments, will be reluctant to support an institutional reform that delegates the design and execution of monetary and exchange policies to a group of technocrats with no democratic representation. On the contrary, countries that have experienced triple-digit inflation, or hyperinflation, attach a high value to the loss in well-being resulting from the fall in real income and the generalized uncertainty caused by rapid increases in prices. In general, these societies are more aware of the damaging effects of political influence in the conduct of monetary policy.

In addition, the economic conditions prevailing during the first years of the reform are very important. This is particularly true if they run counter to the central bank’s assigned objective of preserving price stability, given that the central bank may still be engaged in the process of consolidating its credibility and reputation. Three types of threat to central bank autonomy are worth mentioning—namely, the fragility of the financial system, the weakness of public finances, and the emergence of adverse external shocks—which may even occur simultaneously. The potential negative impact of these events manifests itself in a combination of capital flight, exchange rate depreciation, interest rate hikes, and ultimately in inflation.

The most serious problem is usually the existence of a fragile financial system. In this environment, market sentiments often turn negative, reflecting the perception of an eventual future banking crisis, which makes it more difficult for central banks to achieve inflation targets. Central banks face the difficult dilemma of whether to abandon, at least temporarily, the original inflation target by relaxing monetary policy to allow lower levels of interest rates to limit adverse effects on impaired financial institutions, or instead to continue pursuing the original objective, at the risk of aggravating financial instability. The dilemma is all the more complicated if the financial fragility entails a systemic risk and, in addition, if the banking crisis is likely to result in a simultaneous currency crisis, which could exacerbate costs in terms of economic activity and inflation. The potential limitations for monetary policy imposed by a situation of financial fragility can be lessened as a result of obtaining compensatory external credits or the adoption of fiscal adjustment.

A second potential problem arises as a result of a persistent expansionary fiscal policy that requires a compensatory monetary restraint, leading to high interest rates and thereby to a lower economic activity. Although the inflation target may be achieved, economic recession may raise adverse reactions against the central bank as long as fiscal policy is not identified as the source of the inflation problem. The observed policy mix might send signals to the market about a lack of coordination between monetary and fiscal policies, a situation that may give rise to uncertainty and expectations of future higher inflation (Worrel, 2000). Additional uncertainty may result if the government accumulates high and increasing ratios of public debt associated with fiscal deficit financing. As a result, capital outflows and interest rate increases may take place, leading to a balance of payments crisis as the market anticipates that the Fiscal deficit is not sustainable.

Adverse external shocks are common events in small open economies. In addition to restricting the availability of foreign currency—and sometimes of fiscal revenues as well—they often trigger capital flight with the resulting upward pressure on the exchange rate and inflation. In order to lessen these effects, central banks tend to raise interest rates at the cost of lowering employment and growth. However, the central bank’s response must, insofar as possible, be sufficiently balanced to avoid an eventual “overadjustment” This is a complex task, given the difficulty of anticipating with a reasonable level of approximation the intensity and length of the external shock. Of greater difficulty still is for the market to identify the appropriate policy response. As a result, the central bank and its autonomy reform will be exposed to criticism in an environment of economic recession, in particular if the institution has yet to establish a solid reputation.

Traditional Functions of Autonomous Central Banks

Given the fundamental objective of preserving price stability, the basic functions assigned to an autonomous central bank are the following: the formulation and execution of monetary policy; the conduct of exchange rate policy and the management of international reserves; the role of lender of last resort (LOLR) in the financial system; the coordination of the payment system in the economy; and the role of fiscal and financial agency on behalf of the government. In some countries, the central bank also carries out banking supervision functions, when no other institution has been independently established to carry out such responsibility, as well as the production of certain economic statistics.

The conduct of monetary policy is based on a financial program elaborated for a given period, typically one year, which is aimed at preserving the value of the domestic currency as its ultimate goal. Central banks must choose monetary instruments that are consistent with the selected operational or intermediate targets and the exchange regime in place. Consistency enables the central bank to send clear signals regarding the direction of monetary policy in the short-run, and thereby to achieve greater effectiveness in meeting its final target. On a daily basis, monetary policy should facilitate liquidity management in the banking system in order to reduce interest rates' volatility in the interbank market and the associated financial costs that tend to be reflected in higher interest rates, and lower economic activity and employment. The management of exchange rate policy must also be consistent with other macroeconomic policies, so as to ensure stability and foster confidence among market participants. Market confidence depends to a great extent on the central bank having international reserves at levels that are adequate to sustain the exchange regime in place and to strengthen the country’s external financial soundness. The central bank is responsible for managing the country’s international reserves safely and efficiently under conditions of liquidity, profitability, and security.

Typically, central banks are given the responsibility of acting as LOLR.7 This support should be considered part of a broad financial safety net, which may also include a well-designed deposit insurance system and flexible mechanisms for banking crises resolution, generally provided and executed by other institutions. LOLR mechanisms are generally aimed at providing liquidity support to impaired but solvent institutions, and comprise basically a central bank automatic liquidity window and an emergency loan facility. In the liquidity window, the automatic resource transfer is usually pursued in exchange for government securities, which minimizes risk to the central bank. Emergency loans are short-run liquidity facilities that are granted in return for high quality collateral and, in many cases, are coupled with an action plan imposed on the recipient bank until its current difficulties are overcome. In some countries, LOLR facilities are also provided to an insolvent institution, insofar as its failure may trigger a systemic crisis (the “too-big-to-fail” argument).

Regarding other functions, the central bank is usually the main protagonist in the functioning of a country’s payment system. It develops policies for operating and modernizing the payments system and acts as settlement agent for the transactions carried out, while limiting its exposure to the risks inherent in these types of transactions. At the same time, the central bank ensures that the payment clearing mechanisms operate properly and provides incentives ensuring mutual cooperation between the parties involved. The modern trend in payment systems is to build real-time gross settlement (RTGS) systems in order to deal with large-value payments in a secure and efficient manner, thereby strengthening the development of interbank markets.

There is no agreement on whether or not central banks should also conduct banking supervision responsibilities. There are pros and cons—their analysis is outside the scope of this document—in this respect that do not allow a conclusive recommendation. In practice, either an independent supervision institution or a central bank in command of this task has succesfully worked.

In addition, the central bank usually provides the government with banking functions for managing its accounts, for receiving deposits—from tax collections, for example—and settling domestic and international liabilities, and for distributing, when necessary, public resources between different state entities. On occasion, the central bank acts on behalf of the government in handling the operational aspects of domestic and foreign credits, and provides advisory support on public debt policies and management. Also, in most developing countries central banks produce key macroeconomic studies that guide not only their own decisions, but also most government economic policies. The elaboration of economic statistics is frequently a responsibility of central banks as well, in particular, in countries where institutional development is still weak, such that reliable and solid statistics cannot be produced by other government entities.

New Challenges for Autonomous Central Banks

While today, countries worldwide are undergoing a period of low inflation in comparison with the two previous decades (Table 2), the global economy has become more prone toward financial instability. Financial crises have increased at the country level, such that they are now the main source of macroeconomic volatility and welfare losses. This situation has prompted the international community to propose a “new international financial architecture” in order to forestall and lessen the high costs of the recent currency and banking crises, and the associated spillover and contagion to other countries.8 The exposure of the global economy—and in particular of the emerging markets—to the volatility of international capital flows and the increase in the number of banking crises in various regions have presented central banks with new challenges, which may affect their traditional functions. Three important issues are briefly analyzed in this section, namely the renewed debate between fixed and flexible exchange regimes and its effects on central bank functions, the role of central banks in banking crises resolution, and the necessity of improving central bank accountability and transparency.

Table 2.Inflation in Various Regions of the World(Annual percent)
Industrial Countries5.62.31.7
Developing Countries39.023.35.8
Western Hemisphere145.463.57.6
Source: World Economic Outlook, October (1999).


Source: World Economic Outlook, October (1999).


Fixed or Flexible Exchange Rates Once Again

Perhaps the most important issue on central banks’ agendas today is the debate on the appropriate selection of the exchange regime to help countries to cope with the volatility of international capital flows. The discussion has been updated in line with the new environment. Most experts are divided between the use of rule-based fixed regimes—also known as “super-fixed” exchange rates—such as currency board arrangements, and the adoption of flexible regimes in the context of “inflation targeting” schemes. Intermediate arrangements, including pure fixed-exchange rate systems, exchange rate bands and crawling peg systems, which were more accepted in previous decades, are increasingly less popular in view of their greater vulnerability in the current circumstances. As an extension of the “super-fixed” regimes, some countries are evaluating the establishment of “dollarization” schemes (a few nations like Panama, and more recently Ecuador and East Timor, have already adopted them), whereby the use of the home currency as legal tender is replaced by the currency of the country’s largest trading partner. The main benefits of “super-fixed” and “flexible/inflation targeting” regimes, including the implications of each of these regimes for central banks' traditional responsibilities, are discussed below. An assessment of the cost associated with each regime is not included, since it goes beyond the scope of this paper.9

As claimed by its adherents, the benefits of flexible regimes are enhanced by the adoption of “inflation targeting” schemes, since this strengthens central bank commitment to price stability and accountability.10 In the current environment of international financial instability, flexible regimes play the role of shock absorbers reducing the effects on the real sector of the economy, in particular on growth and employment, caused by adverse shocks—and encourage market participants to hedge foreign exposures in the event of sudden exchange rate variations. A well-designed “inflation targeting” scheme increases market confidence in the central bank’s ability to confront adverse effects stemming from unexpected exogenous shocks through the adjustment of the exchange rate, coupled with a policy of central bank intervention, if necessary.

However, the implementation of this scheme requires the existence of favorable preconditions. For instance, the central bank must already have earned some reputation in the fight against inflation, so that the new scheme is initiated under a credible basis that will help to accomplish the inflation target. It is recommended that the new scheme be adopted when inflation levels are relatively low or showing a marked downward trend, while having strong fiscal conditions and a sound financial system is strongly advised. Similarly, the central bank should possess a high level of technical sophistication, allowing it to compile and manage information and data, and to build relevant macroeconomic models. Of course, solid central bank autonomy—in terms of clarity of the anti-inflationary objective, and political and economic independence—is essential if the desired results are to be achieved.

Traditional arguments in support of fixed exchange regimes are strengthened when a currency board arrangement is established, limiting or eliminating discretion in monetary policies. Although the central bank loses control over monetary policy as a result of the creation of a monetary rule,11 having a less discretionary policy enhances credibility regarding its fundamental objective of achieving price stability.12 As a result, inflation tends to decrease in the short term, as observed in countries that have adopted currency boards. In addition, the risk of devaluation is lower, compared with the pure fixed-exchange rate system, and interest rates tend to move downward. However, the establishment of this monetary-exchange arrangement also requires certain prerequisites. The first and most obvious is that the central bank must have sufficient international reserves to support the amount of currency issue. It is also recommended that public finances should be solid so as to favor the expected fall in interest rates, and that a sound financial system should be in place, given the limits that central banks face to provide liquidity support under a currency board arrangement.

Recently, the popularity of currency boards is increasingly giving way to “dollarization” schemes, in which the very existence of the central bank is called into question.13 The proponents of such schemes tout their greater benefits by arguing that, with the introduction of the dollar as a legal tender, the risk of devaluation disappears completely, together with the possibility of costly currency crises, so that a country remains insulated from the contagion generated by international financial crises. As a result, it is expected that interest rates will be lower, compared with currency board arrangements, favoring growth and employment. In practical terms, those who support “dollarization” schemes point out that many countries are already de facto “dollarized,” insofar as their assets and liabilities are mostly denominated in foreign currencies. This is the case with countries such as Bolivia, the Philippines, Peru, and Turkey. These arguments add to those that support the existence of a small number of currencies in the world as a means of achieving a better functioning of international economic relations.

The adoption of one exchange regime or another imposes different responsibilities on the central bank. While the introduction of an “inflation targeting” scheme strengthens the described functions of an autonomous central bank and focuses their role around the objective of preserving price stability, the adoption of a currency board arrangement gives rise to significant changes in the functioning of the central bank. The establishment of a monetary rule eliminates the central bank’s capacity to flexibly manage monetary policy, as well as to execute exchange rate policy. In addition, it changes the nature and restricts the use of traditional monetary instruments, reduces the functions associated with the management of the payment system, and requires building unconventional LOLR facilities.

Under “inflation targeting,” the central bank must optimize the use of indirect instruments of monetary policy to maintain a stable and adequate amount of money that is consistent with the target of inflation. The central bank authorities are also obliged to redouble their efforts to compile the information required for the construction of a structural model of the economy and, in particular, a comprehensive analytical framework that allows broad understanding of the dynamics of inflation. As a result, monetary authorities might be able to better anticipate future inflation performance and to adopt the measures required to ensure the achievement of the announced inflation target. The central bank should expand the disclosure of information to educate the market about inflation performance by means of pamphlets, press releases, seminars, and public appearances by the monetary authorities. The success of “inflation targeting” schemes is also predicated on the transparency of the central bank’s policies and practices, including a higher degree of accountability, which is expected to strengthen its reputation and credibility.

With the introduction of a currency board, the independence of monetary policy is lost, in the sense that an automatic monetary mechanism is chosen to ensure price stability. Hence, the central bank is basically responsible for ensuring compliance with the monetary rule, which also supports the maintenance of the exchange system. Open market operations, if at all, are restricted subject to the availability of liquid international reserves—in excess of the amount of money base, for example. Central bank liquidity management remains important in order to prevent large monetary imbalances and interest rate volatility. This is more important in an environment where liquidity fluctuations are common as a result of financial instability, and interest rate arbitrage does not always work efficiently to lessen volatility, in particular, in countries where the monetary market is not well developed. The management of reserve requirements in the central bank also acquires an alternative emphasis, as compared to the approach under a flexible-exchange rate system, since under a currency board arrangement deposits with the central bank may be converted into a “buffer” to confront liquidity shortages. To this end, a higher level of reserves is recommended than if a flexible exchange regime were in place; remunerating deposits in the central bank at market interest rates to avoid imposing costs on financial intermediaries that eventually will lead to an increase in interest rate spreads is also recommended.

Similarly, central bank assistance as LOLR is limited to the availability of foreign reserves in excess of the amount required to ensure the convertibility of its domestic currency obligations. Thus alternative forms of liquidity support must be sought in order to deal with runs on deposits and with temporary liquidity shortages in the financial system. The case of Argentina is illustrative in this regard, where four unconventional instruments have been established, namely, a central bank fund comprising international reserves in excess of those required by the convertibility law; a deposit insurance fund to which banks contribute according to risk-adjusted criteria; an external fund created with dollar-denominated financial assets—working as a put option against a foreign bank in the event of a liquidity need—contributed by domestic financial institutions as a substitute for reserve requirements in the central bank; and the resources available from a set of contingent repurchase contracts with foreign banks that allow the central bank to obtain liquidity in exchange for government debt denominated in dollars. Together, these mechanisms provide coverage to nearly 40 percent of deposits in the Argentinian financial system.

At the same time, central banks would continue carrying out duties on behalf of the government as a fiscal and financial agency, as well as managing international reserves. Coordinating and monitoring the functioning of the economy’s payment system is still possible, although some restrictions may emerge as long as the currency board arrangement is unable to provide LOLR support. The central bank’s involvement in the payment system is also important since it enables monetary authorities to observe and assess the liquidity conditions of all participants, which may serve as an early-warning indicator of potential difficulties experienced by financial institutions.

Should a central bank exist in countries that have adopted a foreign currency as legal tender? The experience of Panama suggests that a central bank is not required under “dollarization.” However, the situation may differ for the transition period, insofar as the adoption of “dollarization” is preceded by a crisis situation that has impeded the timely design of the institutional framework required for the appropriate functioning of the new monetary arrangement. Indeed, not only did the majority of countries that have adopted currency board arrangements in the past few years do so in the midst of severe economic crises—Argentina, Bulgaria, Lithuania, and even Hong Kong SAR are clear examples—but also the recent “dollarization” scheme in Ecuador was adopted under a deep banking and currency crisis.

Under “dollarization,” potential central bank responsibilities are fewer than those described for a currency board arrangement. For example, in Ecuador, the central bank continues issuing temporarily fractional currencies, while at the same time managing the payment system and producing macroeconomic statistics. In general, a central bank under “dollarization” could carry out short-term monetary operations for the purpose of smoothing liquidity fluctuations and interest rate volatility—at least while the financial system is strengthened and the money market developed—and administer a fund under the same parameters used to invest international reserves, which is aimed at confronting eventual liquidity shortfalls. The scope for central banks' involvement in these responsibilities—including the monitoring of the payment system—will be negatively correlated with the degree of foreign banks' participation in the domestic market. Other nontraditional functions that central banks can still perform under “dollarization” are the supervision of the financial system, the production and compilation of economic statistics, and the elaboration of macroeconomic studies, which are fundamental to monitoring and projecting economic behavior. In most developing countries, central banks have become a valuable public good that can hardly be replaced in the short run, considering the lack of solid institutions in the rest of the public sector.

The Role of the Central Bank in Banking Crisis Resolution

Central banks' potential degree of involvement in banking crises was not anticipated appropriately when monetary legal frameworks were reformed during the 1990s to grant central banks greater autonomy. While the reform’s emphasis was placed on reducing inflationary government financing, clear rules were not established for limiting central bank functions as LOLR, nor were basic criteria set forth for central banks on their participation in resolving banking crises. However, the experience of the past few years demonstrates that banking crises are a major cause of the acceleration in inflation in various countries, and that central banks have difficulties in fighting inflation and maintaining their autonomy under these circumstances.

The frequency and the potential costs associated with banking crises have led central banks to become more and more involved in the response to and resolution of financial crises. This is not surprising, in that in most countries central banks remain the most important (if not the only) source of funds available to cope with problems of liquidity shortfalls and, on occasion, of insolvency of financial intermediaries. Also, governments feel tempted to shift to central banks, at least partially, the costs of banking crises with the expectation of hiding these costs within central banks' balance sheets. In general, central banks' involvement in banking crises is more frequent in countries that lack an appropriate institutional and legal framework to confront these crises. As a result of central banks' involvement in financial crises, a monetary expansion is generally expected, in particular when the magnitude of the crisis entails a systemic risk. In this scenario, central banks tend to lose credibility with regard to their ability to maintain control over monetary policy and meet announced inflation targets.

Although the prevention and resolution of banking crises are not direct responsibilities of monetary authorities, in practice central banks have been involved under at least three broad modalities. A first set of operations is linked to conventional LOLR facilities. Problems arise when LOLR mechanisms are not appropriately regulated, in particular in terms of the volume, collateral, and maturities of the loans provided. As a result, the monetization effect may be significant and the quality of assets received in exchange from the impaired banks tends to deteriorate as liquidity assistance increases, adversely affecting a central bank’s financial position. In addition, excessive discretion in the management of LOLR facilities makes central banks vulnerable to political pressures to favor one institution over another, postpone the resolution of the financial crisis, and raise the associated fiscal cost.

A second group of transactions go beyond common LOLR facilities and are intended to facilitate banking crisis resolution. These are observed, for example, when central banks issue securities in exchange for low quality assets of an impaired bank in order to make attractive the bank’s auction or absorption. Several sources of undesirable monetization and quasi-fiscal deficit generation are identified under this arrangement, although their impact will not be observed in the short run. On the one hand, the payment of the interest associated with the bonds issued by the central bank will produce a persistent monetary expansion. On the other hand, there is a potential loss if the value of such bonds (including interest) is not covered by the revenues obtained from the realization of the assets acquired by the central bank. A related case may take place as a result of the discount in the central bank of government securities granted to an impaired bank that is “too big to fail,” in order to allow its continued operation while a restructuring process is under way. In this situation, there is an immediate monetary effect resulting from the injection of liquidity, as well as potential losses for the central bank depending on the financial conditions of the discounted government securities. In particular, losses may occur if these securities are issued at below-market interest rates, while the central bank discounts those securities at nominal value. A more extreme situation may take place if the central bank directly absorbs an impaired bank through a subordinated loan to capitalize the troubled institution, which in addition may require liquidity to ensure its continued operation. In this case, the central bank will end up conducting responsibilities that may conflict with its fundamental goal of preserving price stability.

A third modality arises when central banks are called to execute deposit insurance in exchange for assets of the banks in liquidation. As a result, monetary expansion takes place, which could be significant in the case of a systemic crisis. In addition, central banks may incur a potential loss if the present value resulting from the sale of the assets of the impaired bank is smaller than the value of the resources provided. A related type of operation stems from the direct capitalization by the central bank of deposit insurance funds. In this event, although a monetary impact is produced only when the deposit insurance is activated, the financial position of the central bank may be affected if the resources provided by the central bank are not canceled a posteriori, either by the government or by the contributions of the financial institutions.

The type of transactions previously described are not always correctly reflected in the central banks' financial statements, limiting the recognition of asset values and risks. As a result, quasi-fiscal deficits tend to emerge, hampering the conduct of monetary policy and leading to the deterioration of a central bank’s credibility with respect to the fulfillment of policy targets. In order to correct these distortions, sooner or later the adoption of a restrictive fiscal policy is required, aimed at compensating the central bank’s financial burden that has been inappropriately assumed. A transparent involvement of central banks in banking crises should follow the principle of placing the costs of the crises in the government budget, which implies accounting a central bank’s transactions at market values according to international best practices.

The Challenge of Improving Central Bank Accountability and Transparency

After several years of experience with the autonomy reform of central banks, accountability still is a factor that has not been appropriately executed, especially in developing countries, in spite of the independence granted to monetary authorities. In many cases, central banks' authorities do not inform the executive branch or the legislature about the actions and policies conducted through a given period or, if they do, the report is not appropriately focused on relevant central bank responsibilities. The most common accountability procedure is the publication of a broad annual report, covering all central bank activities, including monetary policies, which is normally published with a significant lag.

The insufficient practical accountability observed in many cases has strengthened opinions that consider that the autonomy reform of central banks is not consistent with democratic practices. Stiglitz (1998) argues that although monetary policy is a key determinant of the economy’s macroeconomic performance, the decisions adopted by the central bank involve trade-offs—mainly between inflation and unemployment—and the most important decisions are discussed in secrecy by a group of people in the central bank that is not representative of the general public. In the end, the head (of the country) “is held accountable for how the economy performs—whether or not he has much control.” Stiglitz’s proposal points to strengthening central bank accountability and to increasing transparency in policy decisions and formulation.

The enhancement of accountability and transparency is today a common trend in most central banks. Central banks' governors are required to appear before a designated public authority to report on the conduct of monetary policy—as well as other activities developed by the central bank—and to assess the achievement of the announced policy target. The improvement of accountability is required not only in relation to monetary policy but also in terms of the financial statements of the central bank. The enhancement of transparency is based on the hypothesis that it will strengthen credibility and reinforce reputation. In addition, it is believed that transparency will underpin monetary policy effectiveness, as long as the market knows and understands the goals and instruments of policy and, in particular, if there is a public and credible commitment of monetary authorities to fight inflation. Macroeconomic performance is also expected to improve, given that the market will be able to elaborate expectations and adopt decisions in a more informed environment conducive to better results. In many industrial countries, the implementation of “inflation targeting” schemes has strengthened accountability, since this policy requires public, long-term commitments and abundant disclosure of information, including monthly inflation reports. This course of action has been followed by some developing countries, although not all countries are ready yet to implement “inflation targeting” as explained above.

The international financial community also favors better transparency on central bank policies as part of the building of the New International Financial Architecture, The former Interim Committee recently called on relevant international financial institutions and the IMF to build a code of transparency practices for monetary and financial policies. The Code of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles was approved in September 1999, and currently serves as a basis for IMF’s technical assistance missions to member countries. It is also a key component of the Financial Sector Assessment Program (FSAP) conducted jointly by the IMF and the World Bank, which is aimed at identifying financial system strengths and vulnerabilities and helping develop appropriate policy responses.14

The Code is increasingly a guide for transparency enhancement worldwide. In its monetary component, the Code emphasizes the following central bank policies and procedures: (i) the clarity of roles, responsibilities, and objectives of central banks for monetary policy; (ii) an open process for formulating and reporting monetary policy decisions; (iii) the public availability of information on monetary policy; and (iv) the accountability and assurances of integrity by the central bank. Although the principles behind this code of good practices are an appropriate guide for policymakers in the central bank, they are not a straightjacket that should be identically applied in all countries. They provide enough flexibility to consider particular situations where increased transparency could endanger the effectiveness of monetary policy and threaten market stability.


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Luis Jácome Hidalgo, as a former central bank governor of Ecuador, is uniquely well suited to provide us with an excellent overview of, and perspective on, recent trends in central banking—and he has done that in this paper. Mr. Jácome begins by observing that the focus of central banks is continuously evolving. At the beginning of the 1990s, the focus was on establishing central banks in transition economies in Eastern Europe and the former Soviet Union, and on taming inflation through greater focus on price stability as the main goal of monetary policy. During the decade, attention has shifted to dealing with the increased volatility of international financial markets, including periodic financial crises, in the context of more independence on the part of central banks. Specifically, Mr. Jácome directs our attention to the choice of exchange rate regimes, the role of central banks in resolving financial crises, and achieving more transparency and accountability in monetary policy. As a starting point, however, he reviews “best practices” with respect to central bank independence.

Mr. Jácome follows current convention in distinguishing between instrument independence and goal or political independence for central banks, and notes that there is more consensus for central banks having autonomy in the use of monetary instruments than in the establishment of goals for monetary policy.1 He observes that conventional wisdom favors central banks be assigned, at least with respect to monetary policies, a single and clear mandate, namely, preserving price stability. In this regard, it may be useful to draw a distinction that the consensus pertains to there being a preeminent goal for monetary policy. Mr. Jácome acknowledges that central banks typically are given other responsibilities, such as being financial agent and advisor to the government and banking supervisor, and I would add protecting against systemic vulnerability—that is, ensuring that the financial system functions smoothly without significant interruption or crisis. One of the difficulties is that the consensus in current thinking about the goals of the central bank may only pertain to monetary policy. The central bank should focus on controlling inflation, rather than on, say, running and owning other financial enterprises, economic development, or lowering unemployment. It is all right for the central bank to promote the development of financial markets or lower unemployment, but only to the extent that this does not conflict with its primary goal of maintaining price stability. However, the course is less clear concerning how the central bank should deal with conflicts among its objectives for monetary policy (typically price stability) and its other financial roles, including in particular maintaining the stability of the financial system. I agree with Mr. Jácome that clear rules have generally not been established for how central banks should operate in resolving a financial crisis, nor in how they should balance their responsibilities in avoiding crises and maintaining price stability, which is the primary responsibility of monetary policy.

With respect to the goal of price stability, Mr. Jácome presents data indicating that tremendous progress was achieved on that score during the 1990s, especially at the end of the decade—both in industrial and in developing countries. Monetary policy had two strong allies, however, low and falling oil prices and rapid productivity growth. The recent tripling in oil prices will once again present monetary authorities with a difficult test. Let us hope that much has been learned since the 1970s, and that those mistakes will not be repeated.

With respect to the choice of exchange/monetary regime, Mr. Jácome calls attention to the growing popularity of “inflation targeting,” on the one hand, and “super-fixed” exchange rates—such as currency board arrangements or dollarization—on the other hand. Intermediate arrangements, such as crawling peg systems, have become less popular due to their greater vulnerability to current circumstances involving increased globalization and volatility of financial markets.

The role of the central bank in banking crisis resolution is difficult, to say the least. One reason is that the lender-of-last-resort (LOLR) function can conflict with the objective of maintaining price stability. In this regard, it is important to distinguish the role of the central bank with its routine lending to banks that are temporarily short of liquidity for overnight clearing, which is also sometimes referred to as LOLR. The context in which LOLR is used here is much more serious. Because LOLR can involve the commitment of substantial sums of public funds, decisions to undertake such lending may be made jointly with the government or ministry of finance. An important point that Mr. Jácome makes is that the extent of central bank involvement in banking crises was not anticipated appropriately when monetary legal frameworks were established (including those reformed during the 1990s), and appropriate guidelines for their involvement are generally lacking. For example, if the central bank is too aggressive in its LOLR role, it could become financially weakened to the point that its independence and capacity to conduct monetary policy would be seriously undermined.2 In addition to crisis resolution, I would argue that the central bank generally has an important role in preventing financial crises and overseeing the smooth operation of the financial system, which is specifically mandated in some central bank laws.

Mr. Jácome points to two factors that are leading to more accountability and transparency in monetary policies: the fact that more central banks have been granted at least instrument independence; and an attempt on the part of international financial leaders to erect a “New International Financial Architecture” in the wake of the recent financial crisis of 1997–98. With independence comes an obligation for accountability. In addition, it is thought that transparency plays a constructive role in avoiding financial crises, or in minimizing their effects once they occur. The case for enhanced transparency is also based on the belief that it increases the effectiveness of monetary policy and promotes good governance.

Mr. Jácome notes that the IMF has taken a leading role in the efforts to improve transparency in monetary and financial policies, particularly in its adoption of the Code of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles, which was adopted by the Interim Committee of the Fund on September 26, 1999. Assessing observance of this code has become a standard part of the combined IMF/World Bank Financial Sector Assessment Program (FSAP), which seeks to identify financial sector vulnerabilities, in particular countries at their invitation, and to recommend corrective actions. In addition, the Executive Board of the Fund adopted on July 24, 2000, a Supporting Document to the Code of Good Practices on Transparency in Monetary and Financial Policies, which explains and amplifies the provisions of the Code, and provides examples of how different countries implement the broad principles of the code.3 Production of the Supporting Document involved a detailed survey of transparency practices by members of the Fund and extensive consultation with monetary and financial institutions, including seven regional consultative meetings held around the world.

Mr. Jácome rightly notes that in many cases the modalities for executing greater accountability and transparency are vague—and in some cases unsatisfactory. How to achieve more transparency and how much transparency to strive for are areas where central banks are still exploring and finding their way. While it is no doubt correct, as Mr. Jácome says, that there is a trend toward more transparency in monetary policy, there is still a great deal of controversy over the specifics and in particular over implementation. Moreover, representatives from some countries argue that the Code is based on a particular style or system of economic management—political democracy and liberalized market capitalism.

In general, observance of the Code of Good Practices on Transparency in Monetary and Financial Policies seems to be correlated with a country’s stage of economic development and form of government. Transparency of monetary policies may be quite limited in countries in the early stages of development, especially those where democracy has not been strongly established. In some countries, transparency may be viewed as counter to secrecy provisions of the central banking laws or may present a risk to the job security of the central bank’s employees. In such countries, it may be useful to distinguish between information about individual firms and households, where confidentiality is a keystone, and information about monetary policy where transparency has an important role. In addition, some countries that have the legislative and other structural aspects of transparency in place have difficulty with implementation, particularly with providing substantive and timely explanations of changes in monetary policy.

In sum, Mr. Jácome has given readers an excellent overview of the dynamic landscape of central banking. A decade from now, future participants in this seminar series will refer to Mr. Jácome’s paper as a reference point for describing the important central banking developments and issues at the beginning of the twenty-first century.

In this paper, the terms independence and autonomy are used interchangeably, just as they are in most works on the subject. However, some authors distinguish between the two terms, linking autonomy to a central bank’s operational freedom, and independence to the lack of institutional constraints (see IMF, 1998).

A review of the channels through which inflation affects economic growth and of the empirical evidence in that regard may be found in IMF (1996).

The problem of “dynamic inconsistency” refers to the incentives that governments have to change economic targets and policies after the market has elaborated its expectations and taken their decisions in light of the original government announcements.

This recommendation is based on the idea that goal independence involves a definition of the short-run inflation-unemployment trade-off, which incorporates political matters. However, in some countries, like Chile, the definition of the policy goal (i.e., inflation) has been successfully assigned to the central bank.

This is the case of Guatemala, where the members of the Monetary Board—the head of the central bank—are directly appointed by the government and the corporate private sector, including one that represents the private banks, forming a decisionmaking body that is naturally conducive to conflicts of interest.

In Korea, for example, any loss of the central bank should be initially covered by its own legal reserves, and the difference compensated by the government, while profits are transferred to the government after accumulating central bank legal reserves.

The “last resort” criterion refers to a situation in which a bank suffering from a liquidity shortage has already exhausted all mechanisms for obtaining resources from the market before turning to the central bank.

Eichengreen (1999) presents a fully documented discussion of this very timely issue.

For a recent cost-benefit analysis of the exchange regimes considered in this chapter, see the recent paper by LeBaron and McCulloch (2000).

The “inflation targeting” scheme has been adopted in particular in industrial countries such as Canada, Germany, New Zealand, and the United Kingdom, as well as in some developing countries, such as Brazil and Israel.

In general, under a fixed-exchange rate regime money supply tends to adjust passively to money demand.

The popularity of currency boards increased in the 1990s in different regions, such that countries like Argentina, Bulgaria, Bosnia and Herzegovina, Lithuania, and Estonia adopted this monetary and exchange arrangement.

In addition to the recent experiments of Ecuador and East Timor, some Central American countries, in particular El Salvador, are evaluating seriously the adopton of a “dollarizaton” scheme. In Argentina, “dollarization” has been under consideration for a number of years.

The FSAP was launched in May 1999 and has been applied up to now in about a dozen countries. It is intended to cover most of the industrial and developing economies in the next few years.

Instrument independence may be difficult to achieve in practice. One reason is that central banks may lack a portfolio of marketable securities with which to conduct open market operations. In addition, there may be coordination problems with the ministry of finance if treasury bills are used as the primary instrument for mopping up liquidity, or the central bank may lack the financial capacity to issue central bank bills for that purpose.

See Peter Stella. “Do Central Banks Need Capital?” IMF Working Paper 97/83 (July 1997); and Alfredo M. Leone, “Institutional and Operational Aspects of Central Bank Losses,” IMF Paper on Policy Analysis and Assessment 93/14 (September 1993).

Both the Code and the Supporting Document to the Code can be found on the IMF’s external website:

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