Frameworks for Monetary Stability

11 Strengthening Central Bank Independence in Latin America

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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In the late 1980s, most Latin American countries embarked on wide-ranging structural reforms to support their move to more market-oriented economic systems and less distorted macroeconomic management. Financial sector reform was an area that received special attention, and—within it—the reform of the central bank was considered essential. The reforms had similar purposes: i.e., principally to bring about continuity and strength in the fight against inflation and to prevent the misuse of the central bank’s powers.

Strengthening central bank independence has been seen as a necessary condition for sound central bank policies, especially in a framework of more market-oriented policies. This has been part of the broader reforms toward economic deregulation, reduced distortions, transparency and clear market rules, and reorganization and streamlining of central bank operations. At the same time, it must be recognized that the independence of a central bank cannot be introduced in the abstract by just passing a law. A law calling for an independent central bank does not guarantee that the central bank will be able to operate independently, and, similarly, a central bank can operate independently although the law allows for governmental intervention in monetary policy decisions. Central bank independence will depend not only on legislation but also on the political and economic context and the persons involved.

Although the form of application of a central bank law may be more important than the letter of the law, it is nevertheless important to establish by law the institutional framework necessary for conducting independent central bank policies. In recent years in Latin America, there have been major efforts to change practices and back up these changes with new central bank legislation. The focus on central bank independence and rooting out old destructive practices may in fact have been stronger in this region than anywhere else in the world—perhaps reflecting the bad experiences of the recent past. The main issues in the efforts to strengthen central bank independence, which are reflected in the new central bank legislation in Latin America, are the definition of clear objectives for the central bank and the framework necessary to achieve those objectives. This framework defines the role of a central bank’s board, including its power to formulate and implement monetary and exchange policies and the basis for appointments, tenures, and dismissal of its members, and determines how central bank policies in conflict with those of other areas of government are solved and how the needs for transparency and accountability will be accomplished. The framework should include limits on central bank credits to the government, prohibition of certain high-risk or loss-producing functions, and safeguards regarding central banks’ financial integrity.

This paper analyzes how these issues have been dealt with in the new central bank laws enacted in Chile, Argentina, and Venezuela. The paper first presents a brief background of some of the issues and considerations involved in the discussion of central bank independence in Latin America. It then reviews problems and conditions prevailing in these three countries before changes in central bank legislation were introduced. Next it deals with the statutory objectives of central banks and analyzes the central banks’ role in the formulation of monetary and foreign exchange policies. It then discusses the increased accountability required in central banks* policies, reviews the limits imposed on financing of the government and the administration of central banks’ assets, analyzes measures to strengthen the composition and appointment process of central bank boards, and covers measures taken to safeguard central banks’ net worth and financial integrity. Finally, it presents conclusions that can be derived from the experience of recent changes in central bank legislation.

Historical Factors

The misuse of central bank powers was common in Latin America in the recent past. Many central banks not only financed public sector deficits but also embarked on various quasi-fiscal activities that fueled inflation and compromised monetary policy objectives. Leone (1993) describes several activities of central banks that have caused operational (quasi-fiscal) losses, including financing the government at low or no interest rates, directing credit and granting interest subsidies to specific sectors, covering exchange rate guarantees, assuming responsibility for exchange risk on external borrowing, administering multiple exchange rate arrangements, and funding poorly designed deposit insurance schemes. These quasi-fiscal activities often have implied highly expansionary credit through increases in central banks’ unclassified “other assets (items), net” accounts and a reduction in their net worth.

The misuse of central banks was largely the result of the ease with which political authorities were able to implement policies without being subject to budget restrictions because of the central banks’ power to issue currency and the lack of transparency in their operations. But the macroeconomic consequences of central bank expenditures financed by central bank asset expansion (either in the form of credit or losses) are similar to those of domestic fiscal deficits. The main difference is that, usually, there is not an open discussion about how central bank expenditures will be allocated and financed, and Congressional approval is not required. At the same time, some central banks have had specific activities transferred to them by express mandate of Congress.

Most countries are seeking to achieve institutional arrangements that will ensure the effective conduct of monetary (including exchange rate) policy in pursuit of monetary stability. Experience in Latin America and elsewhere has shown that monetary stability requires the maintenance of consistent policies over a long time to build confidence and expectations of continued stability. Based on the Latin American region’s experiences over the last two decades, there has been an emerging consensus that monetary stability can be achieved only with a central bank of established independence because government policies tend to be of too short a term. Monetary policy more than any other economic policy requires a public perception of the central bank as a credible institution for the policy to be effective.

All economic policy is subject to scrutiny by elected officials and the public. Therefore, no central bank is totally independent as they all have to respond to public opinion, legislative inquiries, and political realities. However, it is important that the central bank have clear objectives and maintain transparency in its policies and operations, and that the inevitable policy conflicts between monetary policy and fiscal and other policy areas be resolved in a clear and transparent manner.

Central bank independence and the relationship between a central bank and the government of any country is determined by historical circumstances and practices developed over time, legislation, and the personalities involved. Legal provisions alone do not guarantee independence as shown in recent studies by Cukierman, Webb, and Neyapti (1992) and Alesina and Summers (1993). These studies have linked central bank independence with lower inflation but it is not clear to what extent the reason for this has been general political stability rather than action of the central bank. The relevance of central bank independence also should be related to the monetary and exchange rate system of any one country; independence is a different matter with a currency board arrangement or a rigidly fixed exchange rate than with other more flexible exchange rate arrangements.

In Latin America, there have been major efforts in recent years to change practices and back up these changes with new central bank legislation. Given the bad experience of the recent past, the focus on central bank independence and rooting out old destructive practices may in fact have been stronger in this region than anywhere else in the world. Chile led the way and became an example for the rest of the region. The major changes in the way central banks operate are reflected in new central bank legislation enacted in Chile (1989), EI Salvador (1991), Argentina (1992), Colombia (1992), Ecuador (1992), Nicaragua (1992), Peru (1992), Venezuela (1992), and Bolivia (1993). In Mexico (1993) the concept of central bank independence was considered important enough to be included as a constitutional change. Other countries in the process of changing legislation are Costa Rica, the Dominican Republic, Guatemala, Guyana, Honduras, Paraguay, and Uruguay. In sum, most countries in the region, except Brazil and those in the Caribbean, have revised or are revising central bank legislation.

The reforms have sought to achieve three types of independence (i.e., political, macroeconomic, and microeconomic or financial independence).1 Political independence involves a clear objective or, ideally, a single objective separated from other policy areas, mechanisms for conflict resolution and accountability of the central bank’s actions to the public. It also involves the establishment of an independent board of directors, who would be appointed for relatively long periods, at staggered terms, and who would not represent specific interest groups. Macroeconomic independence means freedom to formulate monetary and exchange rate policy, use a range of policy instruments to implement such policies, and limit financing to the government and banks. Practices such as direct controls and multiple currency practices are discouraged in favor of market-based intervention techniques, which typically reinforce a central bank’s freedom to act independently. Financial independence requires prudential rules, such as prohibition of exchange rate guarantees and subsidized interest rates, transparent accounting rules, prohibitions on the distribution of profits not received on a cash basis, and linkages of losses and negative net worth to the budget.

Monetary stability cannot be separated from financial stability. A sound banking system and proper prudential supervision of financial institutions are therefore essential. Tuya and Zamalloa (1994) show that banking supervision in Latin America is handled by either a central bank or an independent agency. Regardless of institutional responsibilities, there is a need to coordinate monetary and prudential policies because the proper transmission of monetary policy signals requires a sound financial system and a properly working market. However, the role of central banks in the area of banking supervision is not covered in this paper.

Background Developments

The three countries whose central bank laws are analyzed in this paper had different macroeconomic backgrounds, but also have features in common. Their nonfinancial public sector operations had resulted in deficits, which had been financed, in part, through the central bank. Their financial sectors had suffered crises and the central banks had intervened to solve those crises, thus jeopardizing their monetary policy. High inflation had been another characteristic of these countries, although with different intensity. The introduction of new legislation took place at different stages of macroeconomic adjustment and structural reform programs.

In Chile, the principle of central bank autonomy was included in the 1980 Constitution, with the objective of eliminating Chile’s longstanding practice of financing fiscal deficits with money creation. A new law for the Central Bank of Chile (CBC) was first drafted in 1981, but the discussions were postponed because of a severe financial crisis in 1982–83. Discussions resumed in 1986 and the law was finally approved in 1989, against a background of relative economic stability and following the implementation of wide-ranging structural reforms.2 The nonfinancial public sector balance turned to surplus in 1988 and has remained in surplus. Annual inflation that had averaged about 20 percent in the period 1980–893 decreased to 13 percent in 1988 and reached 21 percent in 1989 when the law was approved.

In Argentina, discussions about reforming the Central Bank Law were initiated in 1989 after an unprecedented episode of hyperinflation. That year, the inflation rate reached about 5,000 percent and the nonfinancial public sector’s balance resulted in a deficit of 12.1 percent of gross domestic product (GDP). In that context, it was almost impossible to implement an independent and credible monetary policy committed to price stability, despite the general consensus that inflation had to be abated and inflationary money creation by the Central Bank of Argentina (CBA) had to be eliminated. In 1990, the annual inflation rate remained at 1,350 percent, and the nonfinancial public sector’s deficit declined to 1.7 percent of GDP, after the fiscal adjustment initiated in April 1990. The turnover of the CBA’s Board was very high during this period (from December 1989 to April 1990, the CBA had five presidents, with one being appointed twice).

The Convertibility Law passed on April 1, 1991 committed the CBA to sell foreign currency at a fixed exchange rate (Arg$l per US$1) and maintain at all times unrestricted international reserves4 in an amount not less than 100 percent of base money. Without reforming the Central Bank Law, the Congress limited the powers of the CBA to finance the public sector and provide credit to banks or other sectors. This law imposed a nominal anchor on the economic program, required fiscal discipline, and gave the Minister of Finance a basis to refuse requests for more expenditure when there was not adequate financing. The Central Bank Law was amended to conform with the Convertibility Law in October 1992. During that year the nonfinancial public sector balance showed a surplus of 0.6 percent of GDP and the inflation rate decelerated to 18 percent.

Venezuela embarked on a program of macroeconomic adjustment and structural reform in 1989. The Central Bank of Venezuela (CBV) liberalized interest rates, removed exchange controls and multiple exchange practices, adopted a flexible exchange rate system, and began developing market-based instruments for its monetary intervention. In 1990, the nonfinancial public sector showed a surplus of 1 percent of GDP and the inflation rate was 36 percent. In mid-1991, several financial sector laws were presented to Congress for consideration. Subsequently, the fiscal situation deteriorated to deficits of 3.3 and 6.2 percent of GDP in 1991 and 1992, respectively, while inflation remained high at about 32 percent during both years. A new Central Bank Law was adopted in December 1992.

Statutory Objectives

It can be expected that central banks with greater formal independence have a statutory objective with a relatively narrow focus. The advantages of having a clearly delimited objective is that a central bank’s policies can be geared to attain that objective, and as a consequence, those policies can be more predictable and their outcome more easily evaluated. On the contrary, multiple objectives make it easy for the central bank to explain the lack of performance with respect to a specific objective because of the intention to attain another result, and economic agents could expect changes in a central bank’s policies because of changes in the importance assigned to each objective.

Until recently, laws in Latin America assigned multiple objectives to central banks. For example, the CBA law of 1977 called on the CBA to regulate credit and medium of payments with the objective of fostering conditions to maintain orderly economic growth, with social justice, high levels of employment, and the purchasing power of the currency. This framework did not rank objectives in terms of priorities, and the CBA could well change its policy and provide subsidized credit to develop specific sectors or promote social justice, and could assign less weight to price stability.

There is consensus that the primary objective for a modern central bank is to maintain the value of the currency. Other functions or objectives of central banks must be subordinated to the attainment of this primary objective. Central bankers should be more concerned about price stability than politicians, and avoid the risks of exploiting a possible short-term trade-off between inflation and growth that does not always exist.5 The commitment of a central bank to fight inflation will give more credibility to its monetary policy, reducing the risk premium included in domestic interest rates for unanticipated changes in policies.

The laws analyzed make the fight against inflation their main objective, although with different degrees of commitment. The high level of inflation suffered by these countries in the past justifies this emphasis. The primary objective assigned to the CBA and the CBC is to maintain the value of the currency. The CBC also has to watch over the normal execution of domestic and external payments. The objectives of the CBV are broader: (1) to create and maintain monetary, credit and exchange conditions that encourage the stability of the currency, foster economic equilibrium, and promote the ordered development of the economy; and (2) to assure the continuity of the country’s international payments.

In the case of Venezuela, although one can argue that the stability of the currency is a necessary precondition to promote long-term economic growth, the way in which the objective of the CBV has been worded dilutes the commitment to fight inflation.

Monetary and Foreign Exchange Policies

The definition of the objectives of a central bank is not enough to reflect the formal independence from government; several other issues must be considered. Once primary objectives have been assigned to a central bank, the next issue is how much freedom should be assigned to its Board of Directors to formulate monetary and exchange rate policies in pursuit of those objectives, without interferences from other areas of government. Even when the objectives of the central bank are well defined, it is necessary for the central bank to have the power to formulate and implement policies to achieve them. After the responsibilities in formulating monetary and exchange rate policies have been delimited, the issues to address are how those policies are to be coordinated with other areas of government and what mechanisms are to be used to resolve conflicts when they appear.

Responsibilities in Formulating Policies

Monetary and foreign exchange policies must be coordinated and independence in formulating the one could be affected by interferences in formulating the other. The role of the central bank in formulating monetary policy is unquestionable, although its independence from other areas of government to do so is not always clearly stated. In Argentina, the law establishes clearly that in formulating and implementing monetary and financial policy, the CBA shall not be subject to orders, directions, or instructions issued by the Executive; the policy shall be aimed at attaining the primary objective of the CBA, pursuant to the laws enacted by the Congress. In Chile, the Board of the CBC has to take due account of the government’s general economic policy stance when adopting its decisions. In Venezuela, the Board of the CBV has to approve semiannual monetary policy guide lines, although the law requires that the CBV regulate credit activities of banks and other public and private financial institutions to foster compatibility with the goals of monetary and fiscal policies.

With respect to foreign exchange policy, the role assigned to the central bank is typically more limited. It is different in each of the three countries analyzed. In Argentina, the central bank implements the policy set by Congress; in Chile, the law already defines the policy; and in Venezuela, the policy is set with agreement of the Executive Branch of the government.

The Central Bank of Argentina has to implement overall foreign exchange policy pursuant to the laws enacted by Congress. This refers especially to the Convertibility Law that establishes a fixed exchange rate rule and sets a kind of currency board agreement that requires the CBA to maintain unrestricted international reserves to fully cover base money. The Convertibility Law thus conditions the CBA’s independence to formulate monetary policy.

The Chilean law states that any person may freely undertake international foreign exchange transactions and that the rate of exchange shall be freely established by agreement among the parties involved. At the same time, the CBC is authorized to impose certain restrictions on international foreign exchange transactions, by means of a decision of the majority of the Board for the purpose of preserving the stability of the currency or of financing the balance of payments, and for a pre-established period of time not to exceed a maximum of one year.

In Venezuela, the Board of the CBV, in agreement with the Executive, sets the prices in local currency for the purchase and sale of foreign exchange, and when deemed advantageous, and with prior consent of the Executive, the CBV may allow the rate or rates of exchange to float freely in the market. The influence of the Executive in setting the foreign exchange policy could affect the independence of monetary policy.

Coordination of Economic Policies

Economic policies must be consistent while multiple objectives are being pursued. In this sense, not only monetary and foreign exchange policies must be coordinated, but they also must be coordinated with policies of other areas of government, especially fiscal policy. Of course, this entails a risk that monetary and foreign exchange policies may end up being conditioned by other policies, and, as a consequence, that the central bank may be unable to achieve its objective of preserving the value of currency. It is necessary, therefore, to establish mechanisms to coordinate policies and resolve conflicts when they appear, while trying to preserve the independence of the central bank. The legislation should provide as detailed and clear a formal framework as possible to coordinate policies and resolve conflicts. Otherwise coordination and solutions will be left to informal mechanisms that largely will depend on the persons involved.

In Argentina, a provision included in the law allows the Minister of Economy or his representative to take part in the meetings of the Board of the CBA, with the right to be heard but not to vote. Also the CBA is required to advise the Ministry of Economy and the Congress on all matters relating to the foreign exchange system. The CBA law does not establish other mechanisms to coordinate policies nor does it recognize the possibility of conflicts.

In Chile, the issues of policy coordination and resolution of conflicts are dealt with formally in the law. The Minister of Finance may attend Board meetings without the right to vote, but he also may propose to the Board orally or in writing the adoption of specific decisions and the Board is required to deal with such proposals at the following session. The Minister of Finance also has the right to suspend the application of any decision or resolution that the Board may adopt during the session he is attending, for a period not to exceed 15 days from the date of the session in question, unless all the members of the Board insist on its application, in which case the suspension shall not be implemented. In the event of a suspension of the implementation of a Board decision or resolution, the Minister of Finance may require the Chairman of the Board to convene an extraordinary session to deal with the subject of the suspension.

The Chilean law also establishes that any interested party may lodge an appeal with the Court of Appeals of Santiago against any decision, regulation, resolution, order, or instruction that the CBC may issue in exercising its powers to control the amount of money in circulation and credit, regulate the financial system and the capital market, safeguard the stability of the financial system, or apply sanctions because of violations in foreign exchange transactions. The law establishes the process by which the case should be heard.

In Venezuela, the law requires that the CBV cooperate with the government in the coordination of monetary and fiscal policy and must render an opinion to the Ministry of Finance when the public sector plans to issue debt instruments. Also the law establishes a General Assembly of the CBV, constituted of a minister or ministers designated by the President of the Republic, to represent the government in its capacity as the only stockholder of the central bank. The General Assembly meets semiannually and is empowered to review the results of monetary policy activities; the CBV also can call an extraordinary Assembly to discuss issues of interest. The law does not establish how disputes are settled when fiscal and monetary policies are not consistent, but requires that the Board or the President of the CBV recommend measures to the Executive when considered necessary to avoid impediments in the normal progress of the CBV or in the economic or financial situation.

Another issue related to the coordination of policies, regardless of whether the law requires a formal coordination or not, is the information available to the central bank and other areas of government. Although the central bank must be adequately informed about the cash flow of the public sector, the information about public finances is not always available in good time and form in Latin America. Therefore, the legislation has tried to cover this issue. The CBA law requires, on the one hand, that the Ministry of Economy supply the CBA with quarterly information, while the CBA shall request from the Ministry of Economy, as well as from other ministries and public agencies, any other information that is necessary or useful to it for better fulfillment of its functions. On the other hand, the CBA must report to the Ministry of Economy on monetary, financial, foreign exchange, flow of funds, and balance of payments developments. The CBV law also prescribes the periodicity with which the Ministry of Finance must send to the CBV information about actual cash-flow movements and projections.

Central Bank Accountability

Central banks must be subject to strong accountability and monitoring mechanisms when they are granted more independence to achieve their objectives; otherwise, central bankers could develop their own internal objectives and motivations. Central banks’ objectives and policies must be clearly stated and their actions must be transparent to the public, so that they can be monitored and judged. In addition, the independence to formulate monetary policy is usually accompanied by administrative and financial independence; therefore, it is also required that central banks’ administrative and financial actions can be monitored.

In Argentina, the President of the central bank has to appear before appropriate Commissions of Congress, at least once a year, for the purpose of rendering a report on the developments in monetary, foreign exchange, and financial policies under way. The CBA has to prepare an annual report and publish, not later than the following week, a summary statement of its assets and liabilities at the close of operations on the seventh, fifteenth, twenty-third, and last day of each month. Under the Convertibility Law, the CBA also publishes weekly the amount of unrestricted international reserves that support its base money; this is the main indicator monitored by the public on CBA’s actions. In addition, the CBA has to compile and publish monetary and financial statistics on a regular basis. The observance by the CBA of the provisions of the law and other applicable regulations is monitored by auditors appointed by the Executive with the Senate’s agreement. The auditors report to the Board, the Executive, and the Congress. CBA’s accounting operations and its budget are also monitored ex post by the external agencies providing control of the public sector (Sindicatura General de la Nación and Auditoría General de la Nación).

In Chile, in addition to the usual requirements on publication of an annual report and monthly financial statements, the CBC has to follow more specific mechanisms of accountability. The CBC must inform the President of the Republic and the Senate of any general rules and policies that it may establish in the exercise of its powers. Also, the Board must present to the Minister of Finance and the Senate, each year before September 30, an assessment of progress made in implementing policies and programs for the current year, as well as a report on proposals for the following calendar year showing the general economic projections on which they are based and the probable implications for the CBC’s financial statements.

In Venezuela, at the semiannual General Assembly, the CBV Board presents a report, along with the results of monetary policy, the balance sheet, the semiannual accounts, and the auditors’ reports. This information is made available also to Congress and the general public. The CBV is subject to inspection and supervision by the Superinten-dency of Banks, and the CBV’s operations are subject to an ex post review by the Comptroller General of the Republic.

Although previous legislation has required central banks to publish their financial statements, it has been a common practice to follow special accounting rules, in some cases based on specific laws or regulations. For example, the interest paid on reserve requirements or other central bank liabilities was included in the asset side of the balance sheet instead of in the profit and loss account; similar criteria were followed with the interest paid on foreign exchange liabilities; or assets received from institutions in liquidation were registered in excess of their market value.

Because such practices reduced transparency in central bank operations, modern central bank legislation has tried to eliminate them. In the three cases analyzed, the central bank’s accounting statements must be drawn up in accordance with generally accepted standards, following the general principles established by the Superintendency for all financial institutions. In the case of Venezuela, the CBV law allows special accounting rules because of the special nature of CBV’s operations. In all three cases, the statements must be accompanied by the opinion of external auditors designated by the Central Bank Board.

Limits on Financing the Government

The independence of central banks often has been associated with the powers to limit the credit that they can grant to the government and specific sectors.6 This is another way to reduce uncertainty about monetary and fiscal policies. Governments have used the monopoly to issue money granted to central banks to obtain financing for their deficits. When the central bank is no longer allowed to finance the government, the possibility of creating money in excess of what is demanded because of political pressures is reduced.7 Governments are forced to obey budget restrictions or to borrow from the market (at market rates) to finance their deficits; as a consequence, more fiscal discipline is attained and the development of a government bond market is promoted.

It must be recognized that the establishment of legal limits on central banks’ claims on government does not necessarily guarantee that central banks will be safe from pressure from governments looking for financing alternatives. Central banks may end up providing the required financing to governments through indirect mechanisms that “legally” circumvent the legal constraints, or those constraints can be changed. But such actions will have a political cost for those that take them,8 the cost being higher when the public gives higher priority to the fight against inflation. Given the long history of central bank lending to finance public sector deficits, the limits on credit to the government introduced in central bank legislation typically apply to new debt; the old debt usually remains on the books of the central banks.9

The definition of credit limits is important for their effectiveness in controlling the money supply. A first distinction could be drawn between gross and net credit; usually limits are placed on a central bank’s gross claims, without considering its liabilities. When government deposits are placed at the central bank, a withdrawal of those deposits will increase the net credit of the central bank to the government, but will not increase its gross credit. Although the deposit withdrawal will have a monetary impact as a credit, the government will not be able to use this mechanism as a continuous source of financing expenditures because the amount of deposits is limited.10 Another distinction that is commonly made is between direct and indirect credit. If indirect credit does not have a limit, then the enforcement of direct limits could end up having very little impact on fiscal discipline.

In Argentina, the CBA is prohibited from granting loans and guaranteeing or endorsing bills of exchange and other obligations of the National Government, provinces, municipalities, and other public institutions. The CBA may only finance the National Government by buying, at market prices, negotiable instruments issued by the National Treasury.11 But this indirect lending has two limits: one on the flow and another on the stock. CBA’s holdings of public securities, at par value, cannot grow more than 10 percent per calendar year, and public securities valued at market prices cannot constitute more than one-third of the unrestricted reserves kept as common guarantee of base money.12

In Chile, the CBC under no circumstances may guarantee or acquire instruments issued by the state, its agencies, or enterprises. No public expenditure may be financed by means of funds coming directly or indirectly from the CBC. Only in case of foreign war, or the threat thereof, is the CBC authorized to finance the state and public or private enterprises.

The CBV may not grant direct credits to the National Government, or guarantee obligations of the Republic, federal entities, municipalities, autonomous institutions, state companies, or any other public sector entity. In addition, the CBV may not guarantee the placement of securities. The acquisition of public and private securities by the CBV, through open market operations, must conform to the monetary policy guidelines approved by its Board of Directors.

Limits on Lending

Functions assigned to a central bank could affect the management of its portfolio and the control of the money supply, if they are not subordinated to its primary objective. In this sense, during the 1980s, central banks acted as lender of last resort to stabilize the financial system during banking crises, paid for deposits when banks were liquidated, or intervened for banks and assumed their liabilities. These actions affected monetary policies as the central banks incurred losses and created money.

The CBA law is the most rigid in preserving CBA’s autonomy to control the money supply—as a consequence of the Convertibility Law. The CBA can only grant limited credit to financial institutions for liquidity problems and perform open market operations with the objective of regulating monetary conditions; it is prohibited from lending to persons or private enterprises. The law prohibits the CBA from granting special guarantees that directly or indirectly, implicitly or explicitly, cover obligations of financial institutions, including those originating in the acceptance of deposits. The CBA is only authorized to grant advances to financial institutions for temporary illiquidity, with proper collateral, for a period no longer than 30 days, and in amounts not to exceed under any circumstances the institution’s net worth. No other public institution provides deposit protection or financial assistance to problem banks.

In Chile, the CBC may provide financing or refinancing only to banking and financial institutions, without limits. For the purpose of safeguarding the stability of the financial system, the CBC is empowered to (1) grant loans to financial institutions in case of emergency for a period not to exceed 90 days, when problems stem from temporary illiquidity, or (2) grant loans or acquire assets from financial institutions to facilitate the devolution of deposits. In the case of liquidation, the CBC can advance funds to facilitate the devolution of demand deposits, other sight obligations, and term deposits with less than ten days to maturity at the time of liquidation.

In Venezuela, the CBV is authorized to grant loans to financial institutions up to 30 days, guaranteed by credit instruments, and also to lend to the Deposit Guarantee Fund (FOGADE).13 The CBV is also authorized to discount and rediscount securities arising from operations related to agricultural activities determined by the Executive.

Rules Governing Central Bank Boards

The degree of formal independence of a central bank also depends on the composition of its board, and how board members are appointed and removed from their post. The study by Cukierman, Webb, and Neyapti (1992) found that the legal term of office did not seem to have much effect on the actual turnover rate of board members in developing countries, with political authorities frequently firing those who challenged them and choosing those who were loyal. The new trend is to give stability to boards and limit government intervention, so that they can perform their duties without short-term pressures. New legislation (1) limits the government’s appointment and dismissal powers, (2) involves more than the Executive Branch of governments, (3) requires individual board members to have technical expertise on central bank matters and not represent interest groups, and (4) sets relatively long and staggered terms for directors. The latter rule reduces the scope for governments to influence central bank boards with their own appointees.

In Argentina, the Board of the CBA is appointed by the Executive, with the approval of the Senate. Directors serve a six-year term and may be reappointed. The Board is composed of the Chairman, who is also the President of the Central Bank, the Deputy Chairman, and eight Directors; four of the Directors of the first Board remain in office for only half a period. They cannot hold any other position, with the exception of teaching, and they may be dismissed by the Executive, with the prior consent of a committee of Congress,14 for failure to fulfill the provisions contained in the CBA Charter.

In Chile, the Board of the CBC is composed of five members, appointed by the President of the Republic by decree issued via the Ministry of Finance, with the approval of the Senate. The Board members serve for ten years and may be reappointed. Initially, they were appointed for staggered terms, so that one member would change every two years. The Chairman of the Board, who is also the President of the Central Bank, is appointed by the President of the Republic from among the members of the Board for a five-year period or any lesser length of time remaining to him as a Board member.

The position of Board member is incompatible with any employment or service in the private or public sector, whether or not remunerated, with the exception of being in the teaching profession or holding a position in a public or private nonprofit institution or foundation, provided that such position is without pay. Before taking up their duties, the Board members must, under oath, declare their financial situation and state that the disqualifying conditions do not apply; a sworn statement regarding their financial situation must be made also at the time they relinquish their position.

The President of the Republic may separate, with the prior consent of the Senate, the member holding the position of Chairman of the Board of the Central Bank, at the substantiated request of at least three Board members, for failure to implement the policies or the guidelines adopted by the Board. The President of the Republic also may, with sufficient reason and the prior consent of the Senate, separate from office one or all of the members of the Board. Such a dismissal can be founded only on the fact that the member concerned voted in favor of CBC decisions involving a serious and manifest failure to fulfill its basic duty (to watch over the stability of the currency and the normal execution of domestic and external payments), and on condition that the decision concerned was the principal and direct cause of significant damage to the economy of Chile. The member or members concerned may request a hearing by the Senate.

If the conduct of a Board member constitutes an abuse of his capacity as such, seeking to obtain direct or indirect benefits for himself or for others, he may be brought before the Judiciary System,15 which will determine, in an action without appeal, whether any infraction or abuse has occurred. The charge must be brought by the President of the Republic or by the President of the Central Bank or by at least two Board members. While a verdict is pending, the court may decide to temporarily suspend the accused from his Board duties. Once a verdict of guilty of an infraction or of an abuse becomes executory, the member concerned shall immediately cease his functions.

In Venezuela, the President of the CBV, who is exclusively dedicated to the activities of the CBV, is designated by the President of the Republic, with approval of two-thirds of the Senate, serves a five-year term, and may be reappointed. The Board of Directors is composed of six members designated by the President of the Republic, three of them working full time. One of the Directors is selected from among the senior officials of ministries, autonomous institutes, and companies from the public sector, but neither the Minister of Finance nor the acting Minister of Finance may serve as a Director. The terms of Directors are staggered. The periods of the first Directors designated are for two, three, four, five, and six years; subsequently all appointments are for a period of six years.

The President of the Republic, as formally resolved in the Council of Ministers, may dismiss the President (and the Directors) of the CBV due to: (1) serious losses, caused intentionally or through clear negligence, to the capital of the CBV or to the Republic; and (2) failure to perform the responsibilities of the position. The decision, along with the supporting explanation, must be published. The Director selected from the public sector can be replaced by the President of the Republic at any time.

Financial Integrity of Central Banks

Because of their monopoly on issuing currency, central banks have been seen as institutions incapable of incurring losses, and previous legislation dealt only with distribution of central bank profits. The lack of transparency in central banks’ operations and accounting has served to hide the true result of their operations, which often have involved large losses. The new legislation has reduced the scope for operations generating losses and has also called for the restoration of a sound financial position for central banks.

A sound financial position is a necessary prerequisite for independence to formulate policies against inflation. Central bank losses are expansionary and affect the money supply. It is also necessary to distinguish between realized profits or losses that have monetary effects and unrealized ones that have no effect. It is better to implement a new law that requires the central bank to be well capitalized rather than to require budgetary appropriations each year to finance central bank losses. Budgetary dependence increases the risks of government involvement in the formulation of central bank policies.

In Argentina, the CBA’s capital was fixed in an initial balance sheet prepared at the time of enactment of its law. Profits that are not capitalized or applied to the reserve funds shall be transferred freely to the account of the government. There is no reference in the law to realize profits because the Executive applied a line-item veto to the first paragraph of the article of the CBA law that reads: “The earned liquid profits shall be earmarked by priority to capitalizing the bank.” The losses incurred by the CBA in a given period are earmarked against reserves that have been set up in preceding periods and, if the reserves are not sufficient, the losses shall be earmarked to the institution’s capital. The Executive also vetoed a requirement that the National Government shall have to make the pertinent budgetary contribution to replenish any reduction in capital during the following fiscal year.

In Chile, any surpluses produced during a financial year are earmarked for: (1) building up reserves, if decided by the Board, in the amount of up to 10 percent of total surpluses; and (2) taxable profits, the balance outstanding after implementing the provisions of (1), except insofar as a law may require all or part of this sum to be used to increase the capital or reserves of the CBC. The CBC’s capital may be increased, with the consent of a majority of the full membership of the Board of the CBC, by the capitalization of reserves and by adjustments for purposes of monetary correction. With the clear consent of the full membership of the Board, the CBC may ask the Ministry of Finance for a capital increase or for the transfer of specific appropriations to its assets from the funds provided in the National Budget Law. Any losses produced in a financial year shall be absorbed by the duly constituted reserves.

In Venezuela, with the purpose of preserving the financial position of the CBV, the Charter establishes that the CBV can only distribute profits actually received in cash and that the Republic is responsible for replenishing CBV’s capital in the case of losses. Ten percent of net profits are allocated to the General Reserve Fund, which has a limit established by the Board of Directors. The Board of Directors resolves that the remaining profits after deductions for reserves will be transferred to the National Treasury. The CBV can only distribute profits received in cash (not accrued). The compensation by the government of CBV’s operational losses requires budget approval. In the event that fiscal accounts do not allow the budgetary allocation to cover the losses, Congress may authorize the issuance of a special government security at market conditions with a maturity not to exceed five years.


The recent changes in central bank legislation in Latin America seek to address the main concerns that affected central bank independence in the past. They also reflect a consensus that the primary objective for a modern central bank is to maintain the value of the currency. Whether these new laws will be applied consistently is a matter to be decided and proven over the next several years.

More detailed rules have been set regarding the composition of central bank boards and the appointment and tenure of directors. The purpose has been to give central bank boards more stability, with a technical reputation, and preserve them from political or sectoral influences, so that they can perform their duties without short-term pressures. The lack of independence of central bank boards has been a clear limitation in the past for the conduct of independent policies.

The new legislation also has reduced the scope for operations generating losses and called for the restoration of a sound financial position for central banks. It recognizes the possibility of central bank losses and the responsibility of the government to cover those losses and offset the monetary impact. The new administrative and financial independence of central banks has required more transparency in their administrative and financial operations.

The limit on direct credit to the public sector is also a common characteristic of the new laws. This limit forces the government to be constrained to budget restrictions and to borrow from the market to finance possible deficits. In cases where the central bank is authorized to provide indirect credit, this must be granted at market-based conditions. The legislation also emphasizes the use of open market operations to conduct monetary policies, and rediscounts to financial institutions have been limited to the management of liquidity.

With respect to the independence to formulate policies, the record is mixed. Although the CBA is independent from the Executive, its policies are constrained by the fixed exchange rule set by Congress. In Chile, the law grants the CBC great independence from both the Executive and Congress, and also regulates, with a high degree of details, the process of coordination of policies and resolution of conflicts. In Venezuela, the law requires more coordination between the CBV and the Executive to define policies, but does not establish how disputes will be formally settled when there is conflict between fiscal, foreign exchange, and monetary policies.

The changes in legislation also have affected the internal organization of central banks. The definition of a narrow objective and the elimination of traditional controls and regulations have generally implied the need for downsizing the structure of central banks.


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    Castello-Branco, Marta, “Central Bank Independence: The Chilean Case” (unpublished, Washington: International Monetary Fund, September1990).

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    Swinburne, Mark, and MartaCastello-Branco, “Central Bank Independence and Central Bank Functions,” in The Evolving Role of Central Banks,ed. by PatrickDownes and RezaVaez-Zadeh (Washington: International Monetary Fund, 1991).

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For an analysts regarding the appropriate relationship between central banks and governments, see Swinburne and Castello-Branco (1991).


Chile suffered higher inflation during the 1970s.


The concept of unrestricted international reserves includes foreign-currency-denominated securities issued by the treasury and excludes the foreign currency counterpart of reserve requirements on foreign-currency deposits.


Politicians have shown to have higher inter-temporal discount rates. In their decisions, shortterm considerations have outweighed the long-run benefits of price stability.


For a detailed analysis on central bank credit to the government, see Cottarelli (1993).


Still, the central bank will receive pressures to produce inflationary shocks if the government can reduce the real value of its debt, or to expand credit to other sectors to increase the profits that will be passed to the government.


Accountability is essential to detect these mechanisms.


The conditions of old debt have been changed in some cases to improve the financial position of the central bank.


The monetary impact and possible volatility of government deposits highlight the need for policy coordination in the short term, as well as the provision of fiscal cash-flow data to the central bank.


The CBA may also place government securities through direct sate in the market or through financial consortiums, but it cannot subscribe such securities for its own portfolio.


The Convertibility Law forces the CBA to provide indirect credit only in the form of foreign-currency-denominated securities issued by the treasury


FOGADE provides limited deposit insurance and financial assistance to banks facing liquidity or solvency problems.


The Committee shall be presided over by the chairman of Congress and composed of the chairmen of the Budget and Treasury and Finance Committees of both the Senate and the Chamber of Deputies of the Nation.


A division of the Court of Appeals of Santiago.

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