Chapter 3 Some Problems of Developing Countries

International Monetary Fund
Published Date:
September 1966
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THIS chapter, based on the Fund’s experience with the problems of developing countries, discusses two aspects of these problems with which it has been directly concerned. The first section of the chapter outlines the considerations which are most relevant to a program of stabilization, and some of the measures that have been found of service to such a program. The second deals with the contribution that central banks in developing countries can make to the maintenance of stability and the techniques by which these banks’ influence can most successfully be exerted.

Stabilization Problems

The immediate symptom of the need for a stabilization program is frequently the appearance of balance of payments difficulties. The necessary policy response, of course, differs according to the source and duration of the difficulties. In formulating a stabilization program, a judgment has to be made about the nature of these difficulties and at the same time consideration has to be given to the effective policy instruments available to the authorities.

Where the difficulties are of a moderate character, the measures needed are likely to concern the aggregate use of resources rather than their allocation within the economy. On the other hand, if excessive demand has persisted for some time, especially as a result of delay in adopting corrective action, and has created or aggravated imbalances between different sectors of the economy, the measures required to restore external balance must be more fundamental and wide-ranging. The speed of recovery of the balance of payments in these cases depends largely on the ability of the economy to shift resources into desired channels, on conditions in the world market for the country’s products, and on the availability of long-term foreign assistance.

A large number of stand-by arrangements approved by the Fund have been concluded to cope with balance of payments problems of a moderate character. Sometimes the factors leading to such problems have been outside the control of the authorities. There may be an actual or a prospective decline in export prices, a decline in the volume of exports owing to marketing difficulties abroad, a setback to export production because of political uncertainties at home or natural calamities, a decline or delay in foreign aid, or relatively heavy foreign debt repayments falling due within a short period. In a considerable number of instances, also, the foreign exchange reserves held by the countries concerned have been considered to be too low to absorb pressures on the payments position arising from seasonal variations in export earnings. Frequently the problems have arisen from temporary surges of domestic expenditures straining the balance of payments. The purpose of several other stand-by arrangements has been to facilitate the elimination of multiple rates or the liberalization of trade and payments.

In such circumstances, Fund resources have been made available to the member in the form of a stand-by arrangement to meet balance of payments problems, provided, of course, the member has had a program which was judged to be capable of ensuring that the disequilibrium should be temporary. The principal objective of such programs has been the establishment of balance between aggregate supply and demand. The maintenance of this balance has required action to control expenditures within the broad sectors of the economy and sometimes within important segments of each sector. In seeking to ensure an over-all balance, a universal objective has been to eschew methods which lead to or increase reliance upon restrictions on trade and payments, and the discriminatory application of such restrictions.

Frequently, however, the problems with which the member has been confronted have been more deep-seated: the pressures on the balance of payments have been associated with distortions resulting from persistent inflation. Excessive credit expansion to finance private investment or consumption, or to meet wage demands, has at times been an important factor in generating inflation. However, unduly large fiscal deficits financed by bank credit have been by far the more common cause. These deficits have arisen for a variety of reasons. Some are caused by attempts to raise the level of consumption in the economy by giving subsidies on consumer goods. Others arise from increasing operating losses of public enterprises, while still others come from attempts to speed up investment expenditures at the same time as consumption expenditures have been rising. On occasion, the simultaneous occurrence of droughts and other natural disasters, political disturbances, and adverse movements in the terms of trade has further weakened the country’s fiscal position by reducing revenues and increasing expenditures.

In some countries the pace and nature of economic development efforts have generated serious pressures on the balance of payments. Attempts to bring about large and rapid transfers of resources between productive sectors and occupational groups have on occasion been associated with considerable increases in prices. In other countries the balance of payments difficulties have been, at least in part, directly attributable to a concentration on investment in industries with a high import content but with little export potential in the near future, while agriculture and the traditional export sector have received inadequate attention. In the face of stagnant, or an inadequate rise in, exchange earnings and a low level of reserves, these countries have found it difficult to satisfy the import requirements of even well-established industries.

When severe balance of payments pressures have persisted for a number of years, the economy has been left with very meager foreign exchange reserves and often a large volume of commercial arrears or other short-term foreign liabilities. At the same time, the structure of prices and costs has suffered serious distortions as a result of continuing inflation, overvaluation of the currency, restrictions on imports, and the policies of the authorities to isolate certain prices from the general upward movement through subsidies and direct price controls.

The objective of the programs that have been supported by the Fund in inflationary situations has been not only to control inflation and to arrest the decline in foreign reserves and the buildup of debt service obligations, but also to facilitate the channeling of resources in such a manner as will sustain the improvement in the payments position and lay the foundation for sound growth. An essential step has been to examine whether the exchange rate needs to be adjusted to correct disparities between domestic and foreign prices, and to determine the policies to be pursued which would be consistent with financial stability and any rate adjustment.

While the maintenance or eventual restoration of internal and external stability has been the objective of the programs, they have not always envisaged an unchanged price level or the establishment of a balance of payments equilibrium during the period of the stand-by arrangement. Some programs have been based on an upward adjustment in general prices resulting from exchange rate depreciation and other measures aimed at correcting price distortions. Because most domestic prices tend to be inflexible downward, relative price adjustments have usually entailed a general rise in the price level. Once the necessary adjustments have been carried through, however, the objective must be to maintain relative price stability, and by so doing to encourage domestic savings.

As to the balance of payments, programs have generally assumed that there would be an immediate lessening of pressures on imports and other payments as aggregate demand was controlled and as inventories built up during the inflationary phase were dishoarded. Moreover, because of an expected revival of confidence in the currency, the programs have envisaged a return of domestic capital that had sought refuge abroad and an increased flow of public and private foreign capital. In some programs, on the other hand, where the necessary foreign financing was made available, a large increase in imports has been planned, to slow down inflation. It has been recognized that a durable improvement in the balance of payments to which these factors would contribute depends largely on an adequate increase in export and other foreign exchange earnings. Policies designed to achieve this end can succeed only if an environment of reasonable price stability is restored and maintained.

Major policy instruments

Fiscal and Credit Policies

When devising a program to achieve financial stability, the chief emphasis has necessarily to be placed on controlling the expansion of aggregate demand, as it is not possible in the short run to make substantial adjustments in the level of supply. Since excess demand conditions are caused in many countries by fiscal deficits financed unduly by central bank credit, a principal task has been to bring the public sector’s deficit under control within limits compatible with the over-all objective of maintaining or restoring economic stability. To this end, fiscal operations have been reviewed to assess the possibilities of augmenting budgetary resources, of reducing the growth of current expenditures, and of strengthening the financial position of the public enterprises. Generally, it has been necessary to place emphasis on measures which would achieve prompt results.

Measures designed to increase tax revenue have therefore been introduced for the most part in areas where this could be done quickly and where the taxes were most easily collected. Most commonly, the taxes introduced or raised have been those on foreign trade. Elsewhere they have been indirect taxes, particularly on commodities considered to be less essential. Direct taxation has been used less frequently, largely because it has been difficult to get quick and effective results. Nevertheless, a number of programs have included plans for a widening of the tax base, a stricter enforcement of existing income taxes, the collection of tax arrears, and a general improvement in the machinery of tax collection. These reforms are considered important because improvement, even if slow, is essential for the longer-run growth of the economy.

Measures to restrain the growth of government expenditures have been important features of many programs. Some have set specific limits to current or capital expenditures, or both. Particular emphasis has been placed on reducing the growth of the current expenditures of the national government. In countries where the spending plans of state and local governments are an important component of the public finances, attention has been directed to these also. Some programs have included minimum targets for the generation of savings in the public sector (i.e., surpluses of revenues over current expenditures) such as would suffice, in combination with the external financial assistance prospectively available and with the amount which the government could safely borrow from domestic sources, to finance the planned public investment expenditures.

In several countries the most effective measure taken to improve the budgetary position has been to strengthen the cash flows of state-owned enterprises, by adjusting the prices of their goods or services or reducing their costs, thus lessening their dependence on budgetary support. Some of these programs have substantially increased the charges of public utilities and have improved efficiency by better management control and work rules, and by discontinuing certain uneconomic operations.

To improve the fiscal situation the authorities need up-to-date information. For this purpose, it has usually been impossible to depend on budgetary data because of the time lag in the reporting of transactions in the government sector and its agencies. A further difficulty is that comprehensive fiscal data may not be obtainable even with a time lag, owing to the activities of autonomous agencies and the exclusion from the budget of some accounts even within the fiscal sector as narrowly defined. Fortunately, however, the cash flows associated with these transactions are reflected in the government’s position vis-à-vis the banking system, and monetary accounts are available in almost all countries on a comprehensive basis and with only a short time lag. It has therefore been found operationally useful to establish tests of fiscal performance by reference to movements in the net position of the public sector’s bank accounts.

This procedure also provides a basis for more comprehensive financial programing. The needs of the other sectors for credit—given certain assumptions regarding output, prices, and inventories—are dovetailed with the results expected to be achieved by the public sector. If the sum of the resulting claims on the banking system is considered to be inconsistent with the maintenance or restoration of a reasonable degree of stability, additional measures to restrain the over-all demand for credit have to be adopted.

For this purpose, quantitative monetary limitations have usually appeared to be the most practicable. Control of demand has been exercised mainly through the establishment of ceilings on the expansion of the domestic assets of the central bank during the period of the program. If budget deficits have been the primary element in excessive monetary expansion, a separate ceiling may be placed on the extension of credit to the government. These measures have been supplemented where appropriate by provisions relating to other types of central bank assets and by the imposition or maintenance of legal reserve ratio requirements on deposit money banks. It is generally desirable to support these quantitative measures by appropriate changes in interest rates, even though the capital markets in many countries are not sufficiently developed to permit any extensive use of open market operations, and even though high rates of inflation increase the difficulty of achieving an effective interest rate policy.

Exchange Rate Policies

In countries where there has been prolonged inflation, action on the exchange rate has been a major policy instrument. The adjustment of the rate has often been associated with the removal or a substantial liberalization of restrictions on trade and payments. Where a multiple rate system has existed, unification of the rates at a realistic level has similarly facilitated the strengthening of the balance of payments position while avoiding resort to restrictive devices.

Rate adjustments have often been accompanied by changes in export or import taxes. The imposition or raising of export taxes on certain primary commodities, the supply of which is inelastic in the short run, has been designed to absorb part of the windfall profits brought about by the rate adjustment while leaving the producers adequate incentives to exploit the possibilities of expansion. This type of tax has been particularly useful in countries where the existing tax system is unable to respond promptly to the increased incomes of producers in the agricultural and mining sectors. Again, a liberalization of quantitative restrictions, or the removal of penalty rates applying to certain imports as a result of the unification of multiple rates, has been facilitated by an increase in import duties or the imposition of import surcharges. On the other hand, some countries have instituted temporary import subsidies on certain items of general consumption, in order to minimize the impact of the devaluation on the cost of living. The distorting effects of such subsidies on the production and consumption of the commodities concerned, and the burden on the budget, have, however, made these far less common.

In many instances, the immediate political and administrative difficulties of adjusting a highly restrictive or complex exchange system have been considered so great that only a partial or selective adjustment of the exchange system has initially been made. Such adjustments have taken various forms. When the exchange rate has been devalued only partially, subsidies have been given to provide added incentives to some exports, and purchases of imports and other payments have been limited by maintaining restrictions. Elsewhere the existing rate of exchange has been maintained for certain transactions, and the rate for other transactions has been devalued, either directly or indirectly, through exchange taxes and subsidies; or a parallel exchange market, with a free or devalued rate, has been established. Alternatively, a complex multiple rate system has been simplified to a few rates through the elimination of the more appreciated rates. Several countries have been able later to make the further adjustments necessary to establish a single realistic rate of exchange.

The achievement of this objective has not always involved the immediate establishment of a fixed rate, and a number of programs have included a fluctuating exchange rate as a temporary device. The movements in prices and wages following upon the adoption of measures designed to eliminate distortions in the economy have been difficult to estimate. It has, therefore, not been possible to determine an appropriate level for the exchange rate in advance. These difficulties have been even greater where a combination of restrictions and multiple rates has existed, since this has made it virtually impossible to ascertain what exchange rate has actually been in effect. Moreover, there has been uncertainty as to the effectiveness of the immediate measures to bring inflation under control. A fluctuating rate established in these conditions has carried with it the understanding that the rate would be allowed to move in accordance with market forces, and that the authorities should intervene only to maintain orderly market conditions.

Exchange rate flexibility through periodic adjustments has also been an essential part of programs which have been concerned not with the immediate restoration of stability but rather with a deceleration of domestic inflation. Without an adjustment of the rate, domestic price increases are likely to affect exports adversely and shift demand into imports. Some countries, with assistance from the Fund, have therefore included criteria to enable governments to ascertain that official support has not made the exchange rate diverge significantly from the basic market trends. For this purpose, the minimum level at which the net foreign exchange position of the central bank or the banking system is to be maintained during the period of the program has been specified, thus setting limits within which the authorities would intervene in the market to smooth out fluctuations. On this basis it has been understood that the exchange rate should be adjusted from time to time to follow the basic trend in the market. In some programs, movements in the exchange rate have been more directly linked to movements in a domestic price index, with the understanding that periodically the exchange rate is to be adjusted to the increase in prices.

Price and Income Policies

Specific provisions have been included in some programs to adjust prices to realistic levels, mainly in public enterprises. Also there has been provision for the immediate elimination or the gradual removal of price controls where these were hampering production and distorting the allocation of resources.

Wage policies have been of particular concern in some programs because the adequacy of the exchange rate adjustment and the effectiveness of monetary and fiscal measures designed to combat inflation are directly dependent upon wage movements. However, the ability of the authorities to influence the movement in the general level of wages differs widely, depending upon the institutional framework and the nature of the cooperation between the government and the labor unions. Consequently, there have been rather considerable variations in the form of wage policies. In some instances where the stabilization measures included a devaluation and a widespread upward adjustment of relative prices, the program has provided for an initial increase of wages for the public sector to be followed by a period without change. As to the private sector, in countries where the government exercises an effective wage policy through a role as arbitrator, the wage policy to be followed has been indicated. Even where the authorities have little direct role with respect to wage negotiations, the programs have frequently included a wage policy to be implemented by moral suasion. Where there has been doubt as to the effectiveness of the measures to restrain cost increases, the temporary acceptance of a flexible exchange rate policy has been part of the program.

Some comments on implementation

The programs adopted to tide over temporary or minor difficulties in the balance of payments or to support changes in the exchange or restrictive systems have, in general, served their limited purpose. Action in these instances has been mainly concerned with over-all financial programing to maintain internal stability while the corrective measures were taking effect. Where action was taken promptly, there has been little disturbance to domestic cost-price relations, and countries have generally succeeded in stabilizing their economies and in improving the prospects for long-term growth. An important indirect advantage has been the experience gained by the authorities of the countries in formulating and administering over-all financial controls, and, where longer-run development policies have existed, in implementing such policies within the framework of these controls.

Where the problem has been one of prolonged and severe inflation, the experience with the programs has been varied. In some countries the governments have been able to implement them fully with good results; in others, the results have fallen short of expectations because the programs have not been carried out with sufficient determination or have failed to foresee economic or political difficulties.

Sound leadership and public support are prerequisites for successful stabilization efforts. The persistence of inflation over a prolonged period derives, to a large extent, from a failure to resolve by other means the conflicting claims of different social groups, each aiming at a larger share of the national income. In such a situation, not only do the distortions of the price-cost structure deepen with the passage of time but also the antagonisms become more intransigent, magnifying the difficulty of implementing a stabilization program. Thus the success of programs in this situation depends largely on the broad acceptance of the objectives by the main social, political, and economic forces in the nation.

Equally important, in very difficult situations, is the continuity of action over a period of years. A program may be carried through for one year, but evolving political and social pressures or unexpected economic difficulties may lead to an eventual slackening of the efforts or a reversal of policies. These considerations underscore the obstacles which the authorities face when they feel forced to adopt a gradual attack on inflation which is planned to extend over several years.

The implementation of major policy changes with the necessary vigor and speed also calls for efficient and stable administrative machinery. The most complex administrative problems have arisen in the fiscal field in fulfilling the revenue targets and controlling expenditure commitments. Difficulties have also been experienced in collecting the share of the Treasury in the profits of the public enterprises or obtaining repayment of budgetary loans. Further, when budget receipts have not materialized as planned, many governments have not been able to bring about a corresponding reduction in expenditures.

Perhaps the most important area in which action has been less than initially proposed or planned concerns the adjustment of the exchange rate. Usually the maintenance of the external value of the currency has been a major political issue, either as a matter of national prestige or as a symbol of an illusory monetary stability. Moreover, many governments have tended to underestimate the economic benefits of an appropriate exchange rate policy. Some of the immediate effects of a devaluation, such as an increase in the cost of living, with its repercussions on personal incomes, have tended to weigh heavily on their judgment compared with the longer-run gains arising from appropriate incentives to guide the allocation of resources.

In situations where domestic prices were seriously out of line with foreign prices, action taken in the exchange rate field has sometimes proved to be inadequate. Exports did not receive the stimulus needed to sustain an adequate level of activity; restrictions on imports remained severe, thus perpetuating distortions; and expectations about a further change in the rate affected the movement of capital adversely. In an inflationary situation it is no doubt difficult to determine the extent of the necessary adjustment. Moreover, the increase in prices and costs as a result of a devaluation and other measures must be allowed for in determining the extent of devaluation itself. Some countries have not realized how large an adjustment was needed, and the effect of a devaluation has been largely offset by the secondary price increases usually connected with a change in the exchange rate. Moreover, where credit policy has not been sufficiently restrictive, or where the wage line has not been held, the advantage gained by the exchange rate change has been dissipated.

Experience has also shown that in a number of countries inadequate action in restraining the growth of consumption has been an important factor in the failure to realize more satisfactory results from stabilization efforts. Public sector current expenditure in many developing countries has been high relative to revenue, owing inter alia to the provision of extensive social and welfare facilities, subsidies to essential consumer goods or public utilities, or the employment of redundant personnel. The retrenchment of consumption has often proved to be difficult, particularly when some of the expenditures have tended to increase with the growth of population and urbanization.

Major weaknesses have also developed in some programs in the area of incomes policy—particularly in reconciling the claims of various groups to enlarge their relative shares of the national product. Despite the best intentions of the authorities, the broad acceptance of a coherent incomes policy has frequently not been achieved, particularly if there was an initial wage-price spiral due to promised increases in wages beyond the capacity of the economy to sustain.

Other problems which stabilization programs have sometimes failed to overcome have stemmed from the misdirection of investments in the public sector, either to noneconomic ends or into fields in which the country is at a substantial disadvantage. Sometimes, too, expectations about long-term development assistance from foreign sources have not been fulfilled, whether because of domestic difficulties in formulating a plan or in providing the necessary internal resources, or because in the event the aid has been less or received later than anticipated. In a number of instances, lack of long-term assistance has led to excessive use of short-term financing, which in the end has added to balance of payments difficulties. Control over suppliers’ and other short-term and medium-term foreign credits has often proved weak in both debtor and creditor countries.

The Fund has been fully aware of the difficulties that member countries encounter in stabilizing their economies after a prolonged period of inflation but has concluded that the Fund’s purposes would be better served by supporting members’ efforts, even though success in overcoming the difficulties was not always certain, in order to encourage progress toward stability. By providing its resources in the form of stand-by arrangements, the Fund has enabled countries to initiate the process of correcting maladjustments and attaining sound and sustained growth. A number of countries have succeeded in this within a reasonable period, particularly when there has been an adequate exchange rate adjustment and a substantial improvement in the internal financial situation. Past experience indicates that, where bottlenecks in important sectors of the economy exist, stabilization measures should be accompanied by an investment policy designed to remove these bottlenecks in order to foster a quick expansion of output, which could also contribute to a strengthening of the balance of payments. The implementation of such an investment policy requires the timely provision of long-term resources from abroad in suitable form. The Fund has been prepared to provide its own resources in the expectation that countries enabled to adopt appropriate stabilization policies would be more successful in attracting such long-term resources.

Role of a Central Bank

Since its inception, the Fund has been intimately associated with the establishment, reorganization, and operation of central banks in developing countries. As early as 1946, the Government of Ecuador requested the Fund to provide an expert mission to advise on monetary and banking reforms. Since then, the Fund has received many requests for technical assistance in the establishment or reorganization of central banks in developing countries. These requests became particularly numerous following the achievement of independence by a number of African countries. By 1964, the prospect that this phase of the Fund’s work would become active led to the establishment of a Central Banking Service, to provide advice on problems arising in connection with the establishment of new central banks, and through which experts could be made available to assist newer central banking institutions in various specialized fields. The experience that the Fund has gained suggests certain observations on the proper role of a central bank in a developing economy, the instruments of monetary policy that it may use to fulfill this role, and the constitutional provisions that are most likely to make its policies effective.

The first and simplest observation to be made is that each country is unique, and that it would be impossible to establish a “standardized” central bank in any country with a standard set of legal provisions. Similarly, while the constitutions of existing central banks are usually examined carefully when the laws for new banks are being drafted, it has never been found possible for any country to adopt, without amendment, institutional arrangements that have proved appropriate in another country.

It is generally accepted that monetary policy ought to play a part in fostering economic growth. In the search for rapid development, it is sometimes thought that expansionary credit policies can markedly accelerate the pace of development. In the developed countries, the expansion of output that can be obtained by resort to an easy credit policy is rather limited; in the less developed countries, the corresponding limits are even narrower. In general, the developing countries have relatively low incomes and consequently a limited capacity for savings. They have also a relatively undiversified and inelastic productive system that responds only slowly to demands created by an active credit policy. In these circumstances, the monetary authorities are constantly reminded of the line between inflation and loss of international reserves on the one side and a slow rate of growth on the other, particularly in economies where a considerable part of consumption is provided through imports, and where increases in consumption tend to be promptly reflected in the balance of payments position.

Within these circumscribed limits, monetary policy is highly important in these countries. While the low levels of income make it impossible for savings to be high, the fraction of the community’s saving that takes the form of increases in money balances is usually larger in a poor than in a wealthy country. The readiness of the public to increase its holdings of money makes resources available to the monetary system, on the basis of which credit can be extended to the government, the business sector, and other borrowers. As long as the growth in the volume and the composition of the stock of money created by the monetary system are compatible with the desires of the community to hold larger money balances, the financial and economic conditions in the country will remain stable. If, however, the monetary system extends credit more generously to public or private borrowers and the growth of money exceeds this limit, their purchases of goods and services will be stimulated. This in turn will encourage a rise in output if capacity is available; but if domestic demand is already commensurate with the economy’s supply capabilities, a further increase will lead only to a rise in prices or a disproportionate increase in imports. It may also be noted that a readier availability of credit and a higher degree of internal liquidity may tend to discourage borrowing abroad and encourage the outflow of funds. The role of the central bank may be viewed against this background as ensuring that the rate of monetary expansion is neither too low nor too high for the maintenance of internal and external stability.

Such an increase in money will be associated with an increase in the assets of the monetary system on which the financing of development may be based. However, there are some pressing claims on credit so created if development is to be soundly based. A growing economy requires larger international reserves, and a part of the increasing central bank credit will be absorbed in this way, for, even if the government holds the country’s international reserves, the central bank is usually called on to finance these holdings. The financing of these reserves—together with the provision of working capital in the form of inventories of raw materials, work in progress, and stocks for sale—is likely to absorb much of the additional bank credit that can safely be created by the banking system in a developing country.

Provided that these limits are observed, monetary policy implemented by a central bank can make an important contribution to the long-run development of an economy. While most aspects of monetary policy may be considered as being of a relatively short-term nature, the flexible pursuit of policies designed to maintain monetary stability over successive short-term periods can contribute to a general economic atmosphere that is conducive to progress. If this atmosphere is maintained, a central bank can provide leadership in the development, and improvement in the operations, of other financial institutions.

In developing countries that have a fairly extensive banking system, one of the prime responsibilities of the central bank can be to convince the other banks of its willingness to cooperate with them and of the essentiality of their cooperating with it. If this extensive banking system is indigenous to the country, one of the main roles of the central bank may be to provide guidance for its improvement. If the system consists essentially of a group of branches of foreign banks predominantly interested in the financing of foreign trade, the central bank may seek to encourage them to direct their attention more toward domestic investment opportunities, or may consider it desirable to foster the growth of other financial institutions, such as development banks. In other developing countries, where the banking systems are only in an early stage of development, one of the main problems facing a central bank may be to foster the growth of an efficient private banking system as well as other financial institutions.

Instruments of Monetary Policy

There are a number of monetary policy instruments that a central bank may use to meet the problems outlined above. Many of these instruments may be adapted both to foster monetary stability and to encourage the flow of credit to the financing of specific desirable investments. In general, it may be suggested that the first of these objectives should usually have precedence, but the directional effects and possibilities of individual policy decisions should not be disregarded.

In many developing countries, the desire of the community to borrow is heavy and may be rather insensitive to changes in interest rates, unless these are pushed to heights that might be regarded as exorbitant. If the country is undergoing an inflation, the rate of interest, if it is to be effective, may have to be higher still. Interest rates may therefore exert a weaker influence in some of these economies, and greater weight must be given to more direct action on credit than in some of the more developed countries. Nevertheless, the general level of interest rates and the differentials between rates for different uses of credit still exert an influence, of which advantage should be taken when framing policies. In particular, while the effect of interest rates on domestic borrowing and lending desires may be relatively weak, they may exert a stronger influence on the inflow and uses made of foreign capital.

In countries where the banks are accustomed to borrow from the central bank, the total volume of bank assets may be influenced by directly controlling the total amount of central bank rediscounts. (Open market operations, such as are used in some industrial countries, are not practicable in most primary producing countries in the absence of an adequate securities market.) Given a strong demand for credit, the central bank can influence the banks by quantitative controls over its credit to them, and this type of rediscount policy may be one of the most effective instruments for implementing monetary policy.

Rediscount policy may also be used to influence the flow of credit toward desirable uses. If the central bank gives favorable treatment, or limits its rediscounts, to the refinancing of certain types of bank loan, the banks will be encouraged to lend for these purposes. Rediscounting policies that distinguish between different types of transaction may thus encourage those types of activity that the authorities wish to foster. In order to serve a useful purpose, however, they must be carefully devised and efficiently administered.

Many less developed countries have also resorted to methods of monetary control which do not involve changes in bank assets. The most direct method is the imposition by the monetary authority of ceilings on the credit which commercial banks may grant to the public. Such ceilings may be imposed either in absolute amounts or by the use of formulas such as limits on increases over the amounts recorded for past periods. The method of ceilings is undoubtedly effective and well suited for selective controls, but its wide application is open to two risks: arbitrariness in selection where the authorities have free discretion, or rigidity where the ceilings are tied firmly to past performance.

In many countries the technique of variable reserve requirements has proved the most effective. Changes in the required ratio may be used as an instrument of monetary policy, since increases in the required reserves will act as a restraint on bank lending and decreases will serve to encourage the expansion of bank credit. However, in some countries the liquidity ratios remain rather stable and in some their main purpose appears to be to channel credit toward certain users—such as government, public enterprises, and agricultural producers—by recognizing their debt instruments as liquid assets.

When a monetary system has been allowed to get out of control, firm measures are required to restore financial stability. The reduction of a government’s deficit may take time, and, in the interim, even the declining deficit will continue to provide expansionary pressures. A marked reduction in central bank credit to the banks may impose severe strains on individual institutions whose accounts are already under pressure as a result of the stabilization program. Under these circumstances, a general raising of reserve requirements may be the most effective means of putting contractionary pressure on the monetary system. Alternatively, high marginal reserve requirements, i.e., high minimum reserve ratios applied against increases in deposits, as distinct from the absolute level of such deposits, may be an appropriate method of applying effective pressure without imposing a strain on the system. These instruments—ceilings on credit and variable reserve ratios—have proved to be particularly effective in dealing with crisis or near-crisis situations. They may, however, also be applicable after an effective monetary stabilization program has been carried through. Such a program may result in a restoration of confidence, resulting in a return of capital from abroad and an inflow of new foreign investment, which will rebuild reserves. If these flows are large they may have an expansionary impact on the economy.

Relations with the Government

One of the thorniest problems that have arisen in practically every discussion of the statutes for new central banks, or of the revision of existing laws, has been that of the relation between a central bank and its government. It is generally agreed that, as the government has a responsibility for encouraging the development of its country’s resources and for seeking the highest attainable level of employment and rising real incomes, it must also be accountable for monetary policy. At the same time, there is broad agreement that a central bank should possess a sufficient degree of independence to enable it to win and maintain public confidence in the nation’s monetary system and to give objective advice to the government. This problem has been a matter of concern in the older industrialized countries as well as in the newly independent countries, and provisions defining the relations between central banks and their governments differ widely. The Fund’s experience suggests that this is one of the aspects of central banking legislation where great weight must be given to national needs and traditions. It is important, however, that close consultations between the central bank and the government be ensured, so that the bank may be able to make its views known on general economic policy questions well before any decisions are made. It is easier to prevent action being taken that would impair a country’s monetary position than it is to reverse such action.

Foreign Reserves

The mobilization and management of a country’s international reserves is a traditional duty of the central bank. In part, the allocation of this duty to the central bank arises from the tradition calling for a gold reserve to guarantee the convertibility of the national currency. Hence, to ensure public confidence in the note issue it is sometimes required that the central bank maintain a high proportion of its assets in gold and foreign exchange. This provision has often been included at the request of the bank itself, to shield it from pressures for excessive monetary expansion. It is not, however, clear that it is in the best interests of a developing country to immobilize an important part of its foreign reserves. For one thing, this reduces the reserves available for meeting balance of payments difficulties. Moreover, by limiting the monetary liabilities of the central bank, a statutory reserve requirement introduces an absolute ceiling to the money supply which may hamper rather than strengthen the central bank’s efforts to deal with emergency situations. Generally, the authorities should leave a certain degree of flexibility to the central bank to determine the appropriate level of its foreign assets as one element, even though a very important element, in the spectrum of monetary policy objectives.

Commercial Banking by Central Banks

The desirability of a central bank performing commercial banking functions is a subject about which there has been much argument. While many long-established central banks originated as commercial banks, they have practically all striven voluntarily to divest themselves of their commercial banking activities, and by the end of the 1930’s it was widely accepted that this was a proper attitude for a central bank. Yet many of the central banks established since World War II have commercial banking departments.

It has been contended that commercial banking operations give a central bank opportunities to correct gaps and distortions in the credit system. For example, there is often a shortage of banking facilities, especially in the more remote and less populated regions of developing countries. Commercial banks often concentrate on short-term financial operations in the main centers, to the neglect of the credit needs of other areas. The central bank may seek to alleviate these problems by engaging in commercial banking. In addition, it is sometimes maintained that commercial banking operations enable the central bank to obtain first-hand knowledge of economic conditions.

Yet it should be recognized that commercial operations by a central bank may retard the development of a sound banking system and make the implementation of monetary policy more difficult. Commercial banks can grow only if businesses and individuals are willing to hold deposits with them. In a community with relatively few banks, the largest or most respected of them is likely to be the most attractive to depositors. As long as the central bank accepts deposits from nonfinancial institutions, therefore, it may serve to discourage the growth of deposits in other banks. Much more important is that the conduct of commercial business by the central bank is likely to antagonize existing banks, despite any assurances that a central bank may give that its commercial banking department will not compete “unfairly.” The existence of such a department may lead to a conflict of interest between the central bank’s responsibilities for supervising the monetary system and its desire to engage in profitable lending operations. Moreover, if a central bank ventures into less attractive fields in order to overcome an apparent shortage of credit in these areas, it may find itself with a relatively illiquid portfolio that will hamper its flexibility.

This problem has been encountered in a number of countries in recent years, and there have been several instances—most recently in Brazil—where, in recognition of these considerations, the commercial banking and central banking functions have been assigned to separate institutions. Where these functions continue to be combined, it appears desirable that the arguments for separating them should be given further consideration.

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