III The Role of Central Banking in Developing Countries

Charles Collyns
Published Date:
March 1983
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The discussion of Section II presupposed a complex economy, a sophisticated financial system, and a welleducated population. The situation in a developing country when it chooses its central banking institution may be very different. Its economy may be dominated by a limited range of exports and faced by terms of trade beyond domestic control. Its financial system may be rudimentary, based on foreign-owned commercial banks financing commerce and export industries, an informal credit network serving much of the rural economy, and an inherited central banking institution which is essentially a currency board. Its population may be short of workers trained in the technicalities of finance and relatively unsophisticated in appreciating the economic realities of a situation. In these circumstances, an overriding consideration must be to ensure that the new monetary authority will be able to establish credibility as a responsible and effective body that is capable of instilling domestic and foreign confidence in the domestic currency and financial system. At the same time, it must be accepted that the new institution cannot hope to undertake immediately all of the functions of the full-fledged central bank, while the scope for central banking activities would be considerably different from that in a more developed country.

This section takes up three topics in turn. First, it considers the role for monetary policy in a small, developing economy, arguing that the objectives of monetary policy in such an economy must be less ambitious than in a larger, industrial economy. Next, it analyzes how various characteristics of the financial structure in developing countries affect the constraints and opportunities facing the central banking institution. Lastly, it considers how the social and political environment may limit the capabilities of the central banking institution.

The Objectives of Monetary Policy

In Section II, the rationale for an active monetary policy was linked to uncompetitive and slowly adjusting domestic product and factor markets. In economies dominated by such markets, the level of domestic demand would play a key role in determining the levels of output and employment. Such economies are typical of the large, industrial countries. However, consider a small, open economy that exports a high percentage of output at a price substantially independent of the level of exports and whose import prices are fixed irrespective of desired volumes; its terms of trade can be taken as given. In such an economy, production and real income are mainly influenced by the costs of domestic supply and by world rather than domestic demand conditions. In this situation, a monetary injection that boosted domestic spending might increase prices and output of nontraded goods and services, but the multiplier effect would be limited by the small size of this sector of the economy. Inevitably the policy shift would result in balance of payments deficits and loss of reserves (if the exchange rate were fixed) or general inflation (if the exchange rate were allowed to float). In general, the greater is the openness of the economy, the more difficult it is to affect the real economy through active monetary policy.

There are both developed and developing countries which may be characterized as having small, open economies. In developing countries, a high degree of export specialization may leave the economy particularly vulnerable to such exogenous shocks as fluctuations in domestic supply conditions or in prices in world markets. But, while the potential benefits of countercyclical action may be substantial in such conditions, such policy is likely to be inherently costly and difficult to execute. The loss of reserves and the inflation associated with a reflation would have a particularly severe impact in a developing country. Moreover, attempts at fine tuning would be fraught with problems of control. Information and response lags between the first moments of a downturn and the impact of the policy response would be lengthy, while the links between policy instruments and domestic output would be tenuous and uncertain. In these circumstances, it would seem desirable to place the focus of stabilization on the finance of those particularly affected by a shock, rather than on any attempt to offset contraction in one sector by expansion elsewhere. Such a policy must, however, be cautious if the authorities find it difficult to distinguish between temporary shocks, for which a degree of purely financial stabilization may be appropriate, and permanent shifts in the trading environment, which would require eventual real economic adjustment.

Given the difficulties involved in short-run stabilization, the main thrust of monetary policy may be better directed toward establishing the financial conditions required by the long-run development strategy of the economy. In particular, in developing economies that have opted for export-oriented growth based on free trade and the judicious encouragement of private enterprise, it is usually advantageous to achieve a stable exchange rate regime with commitments to maintaining the convertibility of the currency and to minimizing restrictions on capital flows. To maintain confidence in such a system, monetary policy must be broadly compatible with a domestic inflation rate that is close to the world inflation rate and with a current account deficit that is consistent with sustainable capital inflows. An inflation rate higher than generally prevailing in competing countries would lead to a progressive loss of competitiveness, while a persistent balance of payments deficit would lead to rapidly diminishing foreign exchange reserves. Both of these effects would lead to expectations of an eventual devaluation and the imposition of a less liberal exchange control regime.

A rate of domestic inflation above world levels and an unsustainable balance of payments deficit are both symptomatic of high levels of expenditure relative to income or, equivalently, to the expansion of domestic credit at a greater rate than the growth in demand for domestic financial assets. The relative importance of cash and bank deposits in developing country financial sectors implies that the objective of financial stability requires close coordination between the expansion of domestic bank credit and the growth in demand for monetary assets. Short-run discrepancies between the two may be permitted for the sake of financial stabilization, especially if official external funding can be obtained (for example from the export earnings stabilization facility of the European Community or from the International Monetary Fund's compensatory financing facility). But, in general, financial prudence would require that care be taken to guide growth of the money supply and domestic credit in accord with well-chosen targets.6 These targets should be aligned with the development strategy, so as to be compatible with the growth of domestic savings and the expansion of domestic credit required for the national investment program.

In addition, the authorities may seek to guide the allocation of credit in accordance with development priorities rather than permitting commercial banks and other financial institutions to place their loans as they see fit. Such policies are often motivated by the belief that market failures distort private incentives away from their socially optimal levels and would lead to misallocation of investment in the absence of selective credit controls. Much criticism has been directed toward such policies, however, based on skepticism over whether the market is really transmitting inappropriate signals and over whether credit controls are truly effective or lead merely to a rerouting of funds from other sources.

The extent to which the monetary authority can influence domestic interest rates and credit conditions depends on the access residents can obtain to international capital markets and on the strength of preferences for domestic as opposed to foreign-currency denominated assets and liabilities. If residents were able to deposit and borrow freely abroad at given world interest rates, and were indifferent to the denomination of currency, then the attempt to establish independent domestic rates would not be sustainable and monetary policy would have to be passive. In practice, domestic wealth holders do have a certain preference for domestic deposits because of their convenience and lack of exchange risk. The stronger is this preference, the less interest elastic the demand for domestic deposits is likely to be. Moreover, controls on outward capital mobility may be effective at increasing the scope for monetary policy if they succeed in raising the costs of obtaining foreign deposits; they cannnot be completely watertight, however, for in an open economy there will always remain many loopholes available to sophisticated opponents to evade restrictions. At the same time, foreign lenders will wish to limit the value of their loans to any particular developing country: risks of default, costs of rescheduling, lack of local information and foreign exposure regulations all act to reduce the price elasticity of domestic access to foreign credit.7 The less is the elasticity of this access, the more the monetary authority will be able to influence the price and availability of credit to domestic borrowers by varying its own lending operations.

In economies with extensive restrictions on trade and payments, domestic conditions will often be heavily dependent on the authorities' actions. Typically, such economies have maintained overvalued exchange rates. In these circumstances, scarce foreign exchange is conserved by limiting the issue of import licenses or by implementing exchange restrictions. In the latter case, the central banking function of management of foreign exchange reserves acquires a new aspect, that of rationing these resources in accordance with perceived national priorities.

Financial Structure and Monetary Operations

The financial structure of a small, developing country tends to be fairly simple. Typically, the banking system is dominated by several foreign-owned commercial banks, which are branches of multinational banks rather than locally incorporated. Indigenous enterprises are usually either owned by the government or on a relatively small scale. Many of these smaller-scale enterprises, especially in rural areas, would be part of an informal credit network and outside the purview of the monetary authorities.

In such a context, the instruments available for the application of monetary policy are considerably restricted. In more developed financial systems, central banks are able to exercise close control over domestic interest rates or over the availability of domestic credit through the manipulation of discount rates, through open market operations, and through intervention in money markets. The influence of these instruments depends on commercial banks being sensitive to changing domestic credit conditions or at least making conventional responses to policy shifts. These responses may be weak or even absent altogether in a financial structure in which the dominant foreign-owned banks tend (1) to be relatively liquid, (2) to prefer to resort to parent banks rather than to a central banking institution for temporary credit, and (3) to set interest rates with oligopolistic inflexibility. Moreover, open market operations and intervention in money markets are unsuitable instruments for policy intervention if the markets for government securities and short-term commercial paper are shallow; in such circumstances, price responses would tend to be volatile and unpredictable. In addition, induced fluctuations in financial prices would, by increasing the uncertainty of returns in these markets, reduce the liquidity of financial assets, and so act to discourage would-be participants. The result would be to repress the rate of development of these markets.

Monetary policy in developing countries is usually conducted by more direct means. Often the central banking institution is given powers to regulate commercial banks' deposit and lending rates directly and to issue credit guidelines and ceilings. The central banking institution may also influence bank liquidity by manipulating prudential reserve ratios and by controlling its extension of credit to banks and to the government. By use of these instruments, policy may be equally capable of influencing domestic monetary conditions in the medium to long run as via discount rate or open market operations. However, these policy instruments would be less well equipped for day-to-day control for two reasons. First, response lags must inevitably be permitted before insisting on compliance. Second, coercion or moral suasion as opposed to price incentives cannot be applied too frequently or the system of control would be placed under excessive strain.

Another factor is that the attainment of monetary targets consistent with a country's development plan may require more policy intervention than the manipulation of interest rates or the direction of domestic credit. For example, there may be a fundamental incompatibility between the deposit rates needed to generate the required saving, the lending rates required to induce planned investment, and the interest rate spread necessary for bank profitability. To escape such a situation, the monetary authorities may need to adopt an entrepreneurial role in encouraging institutional innovation.8 Domestic saving may be accelerated by setting up new financial institutions—such as credit unions, provident funds, and unit trusts—that offer attractive alternatives to the bank account and the hoarding of cash. Such institutions may require subsidization in their early years, given the infra-structural economies of scale which deter private initiative. Private holding of government securities and commercial paper may be promoted by reducing restrictions on access and by market intervention designed to reduce price fluctuations; both of these actions would enhance the liquidity of these assets. On the credit side, lending for socially desirable investments may be increased by establishing a development bank capable of thorough project assessment and the disbursement of interest rate subsidies. Commercial lending to small-scale and rural enterprises may be encouraged by providing credit guarantees and legal safeguards that would reduce the costs of default.

At the other extreme, some countries have adopted sophisticated programs aimed at establishing their financial sectors as international centers earning foreign exchange through the export of financial services. In such situations, the authorities' role must be directed toward achieving an appropriate balance between the policing of well-advertised standards of behavior that ensure confidence in the probity of the domestic institutions and flexibility in setting these standards so as to promote vigorous market responses to shifting external opportunities. In many such cases, a sharp distinction is drawn between the onshore financial system, which trades in local currency, and the offshore market, which is based on instruments denominated in an international currency. Unless this distinction is preserved by strict controls on transactions between the two sectors, domestic conditions would tend to be dominated by the external financial environment.

The requirements of the lender of last resort and of the bank supervisor in small, developing countries will depend on the prevailing financial structure and on ambitions for reform. These functions will often be undertaken by parent banks to the extent that domestic banks are foreign owned. Parent banks are likely to monitor the branch's operations, to offer financial expertise, and to provide short-term credit to the branch in a crisis—and indeed will often be better equipped to fulfill these functions than would the domestic authorities—in order to maintain the parent bank's international reputation for sound management. In such circumstances, the domestic authorities would retain an important licensing function—the denial of entry to international banks that do not achieve high standards—but need be less concerned with supervising day-to-day operations. Nevertheless, the supervision of foreign exchange, interest rate, and credit control regulations may be particularly necessary in order to guard against the possibility that the few foreign branch banks might take undue advantage of their oligopolistic position in the domestic market.9

On the other hand, in other countries, active regulatory and financial support would be essential if the authorities sought to promote indigenous financial enterprises as a primary objective. Local institutions would be initially at a considerable competitive disadvantage in being unable to trade on a parent bank's reputation. Moreover, bank failure would have a particularly undesirable impact, not so much directly as interrelations between banks may be small in scale, but rather through a strong detrimental effect on attitudes toward indigenous financial institutions in general. Confidence in the domestic financial system may be bolstered by the existence of a lender of last resort and by provision of deposit insurance facilities. But these activities could be prohibitively costly without sufficiently close supervision of bank operations to ensure prudent financial behavior. In a situation with low standards of domestic accounting techniques and inadequacies of information, such supervision would require considerable commitment of central bank resources.

Social and Political Constraints on Central Banking

One obvious constraint on the central banking institution of a small, developing country is a shortage of indigenous personnel who have the training and experience to conduct its business. Often the former central banking institution, such as, for example, a currency board, will have carried out largely mechanical functions and have provided few opportunities for staff to develop operational skills or financial acumen. The senior managers of the foreign-owned banks will tend to be expatriate and in limited supply; they may well be reluctant to leave the private sector and, in any case, may be regarded with some suspicion by the government. Foreign experts may be imported but may lack local knowledge and contacts, may be expensive to hire, 10 and would probably be unwilling to make a long-term commitment. Thus, a constraint on human resources may limit the extent to which the central banking institution can involve itself in certain activities, particularly ones requiring both technical expertise and intensity of application—such as banking supervision and economic research to guide policy selection.

An equally important but more controversial issue is the question of how to ensure that the central banking institution plays an appropriate role in policy selection. The arguments used in Section II to support the independence of the central banking institution are, perhaps, particularly applicable in a developing country. Third World governments have often succumbed to the temptation to use rapid monetary expansion to finance short-term gains that are dissipated in subsequent inflation (or, in extreme cases, hyperinflation). However, even if desired, it is difficult to guarantee the independence of any central banking institution, and especially one in a developing country. This independence may have been achieved in certain developed countries that have constitutionally enshrined the central bank's freedom of action to seek specific objectives. These countries also usually possess established financial communities that would provide firm support for policies aimed at the attainment of monetary stability.

In developing countries, independence de jure may well not be sufficient to ensure independence de facto. For one thing, the local financial community may be either unable or unwilling to provide much assistance to bolster a central banking institution whose policy intentions conflicted with the government's wishes. Indigenous financial institutions might be too poorly established or too closely related to the government by either personal ties or dependence on government favors. Foreign-owned banks, meanwhile, would be reluctant to become closely involved in domestic political issues. Without the support of a powerful ally, the central banking institution may be susceptible to political influence. If the executive board of the central banking institution tried to resist the government's wishes, the government could respond by using its powers of dismissal and appointment to obtain a more sympathetic set of decision makers. These powers would be weakened if they were hedged by legislation that lengthened terms of appointment and established proper judiciary procedures for dismissal. The government might, nevertheless, be able to bring sufficient informal pressure to bear to ensure that even a nominally independent central banking institution would set its policy in accordance with government wishes.

A variety of means has been used in the attempt to bolster the independence of monetary policy; indeed each of the four basic alternatives to the central bank to be discussed in Sections IV-VII employs a distinctive approach to this problem. Essentially, however, these different methods are all permutations on two basic devices. The first is to include directions to or constraints on policy selection in the legislation establishing the central banking institution, with the intention that the setting of limits on the discretionary powers of the central banking institution would also serve to reduce the ability of the government to impose its own will on monetary policy. Selection of such an approach would presuppose a decision that the appropriate form of monetary policy would be largely nondiscretionary, and could only be successful if constitutional and other safeguards were sufficient to prevent the relaxation of the legal restrictions when convenient.

The second device is to transfer a measure of responsibility for monetary policy decisions to an external body, such as a central banking institution shared with other countries or even belonging solely to another country, that would be able to resist home government pressures more successfully. Such an arrangement would typically involve joining a monetary union, which would place constraints on monetary policy and require the acceptance of foreign involvement in domestic affairs.

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

Extreme smallness of a country does not by itself guarantee perfectly price-elastic access to foreign credit because each country’s debt is effectively differentiated from others by its sovereign risk.

A common feature of an unregulated oligopolistic banking structure is a form of financial repression in which banks choose to set deposit interest rates low, often implying negative real returns, and opt for a conservative lending policy. Such a strategy tends to lead to slow growth of financial intermediation, but to ensure steady profits.

Limited numbers of experts may be supplied at subsidized costs by technical assistance programs run by, for example, the Central Banking Department of the International Monetary Fund.

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