IV The Transitional Central Banking Institution

Charles Collyns
Published Date:
March 1983
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The transitional central banking institution, as its name implies, can be seen as a stepping stone in the transformation of a country's monetary authorities from a colonial currency board to a full-fledged central bank. The typical currency board issued domestic currency for foreign exchange and offered limited banking facilities to commercial banks. It did not have the power of fiduciary issue; it did not conduct monetary policy or even provide policy advice; it was not committed to acting as lender of last resort; it did not supervise the banking system or impose any prudential reserve requirements. Its basis lay in a financial system dominated by commercial banks originating in the colonial power, which were expected to be able to mind their own branches, and in a commitment to a fixed parity with the colonial power's currency, which implied a passive monetary policy. The primary raison d'être for the currency board lay in capturing the seigniorage benefits of currency issue for the colony itself. The external value of the currency was guaranteed by the requirement, implicit in the process of currency issue, that the currency be backed 100 percent by foreign exchange reserves.

In contrast, the transitional central banking institution typically conducts a wider range of activities than the currency board, at least acting as banker to the government and to the central bank, and possesses greater powers, including those of fiduciary issue and often bank inspection. Nevertheless, the functions it undertakes are restricted to a narrower range than would be usual for a central bank, and its operations are often subject to both government direction and legal restriction. These characteristics may be viewed as direct responses to the circumstances in which the central banking institution must function in a newly independent, small, developing country.

The transitional central banking institution economizes its use of limited human resources by concentrating workers in certain key functions to the neglect of others. The basic operational tasks of issuing currency, accepting deposits, making loans, and managing foreign exchange reserves may well absorb a high proportion of the technical expertise available. Unless promotion of indigenous banks is a high priority for financial policy, commercial bank supervision provides a good candidate for a relatively low level of involvement, being both skill intensive and in part redundant if the banking system is dominated by foreign-owned banks.

Additional economies in manpower may be obtained by confining responsibility for the analysis and formulation of monetary policy to the finance ministry, leaving the central banking institution in charge of operational matters. The government would be granted an explicit right to override any decision of the central banking institution, while policy coordination may be ensured by giving the finance ministry representation on the monetary authority's board. This division of responsibility would be feasible given the inevitable concentration of monetary policy on the medium rather than the short run; only relatively routine matters would need to be dealt with on a day-to-day basis.

A substantial degree of government control might threaten the credibility of the financial system, however, if the public were to believe that the government was likely to misuse its influence over fiduciary issue. To bolster confidence, legal constraints are typically imposed on the operations of the transitional central banking institution. Two such safeguards are commonly observed, usually in combination: a foreign exchange reserve cover requirement and a limit on the central banking institution's holding of government liabilities.

As mentioned above, the currency board was effectively required to hold 100 percent cover for domestic currency issued. Transitional central banking institutions tend instead to be constrained to hold foreign exchange reserves to at least a certain percentage of their demand liabilities. This formulation reflects the role of the transitional central banking institution as a deposit-accepting institution; in this role, reserve money does not only consist of currency issue but also includes bank deposits with the monetary authority. Expressed in either form, the requirement imposes a legal limit on the fiduciary issue of the central banking institution.11 When the constraint binds, the monetary authority may not increase domestic liquidity by extending domestic credit only but must, in addition, acquire foreign exchange. In practice, central banking institutions would normally aim to operate within the boundary to maintain flexibility in fiduciary issue in the short term. It is also common for the central banking legislation to include a clause allowing temporary relaxation of the rule with the finance minister's consent—although such a clause might partially circumvent the purpose of the constraint.

While the cover requirement clearly restricts the central banking institution's absolute ability to hold government liabilities, it does not prevent it from concentrating a high proportion of its assets into holdings of government debt. The cover requirement is typically supplemented by two separate restrictions on such holdings, often imposed together. The first would limit the purpose for which advances to the government could be extended to the finance of temporary deficiencies in current budgetary revenue; these loans must usually be repaid within a short period after the end of the financial year. The second would limit the central banking institution's overall holding of government debt, including treasury bills and long-term securities as well as loans. This limit may be expressed as a percentage of the government's own average annual revenue over a preceding period or as a percentage of the central banking institution's total demand liabilities.

The most clear-cut examples of the transitional central banking institution are provided by a series of so-called “Monetary Authorities” set up over the last decade in countries which, with one exception, were formerly British colonies: the Central Monetary Authority of Fiji (founded in 1973), the Solomon Islands Monetary Authority (1976), the Seychelles Monetary Authority (1976), the Monetary Authority of Belize (1978), the Maldives Monetary Authority (1981), and the Royal Monetary Authority of Bhutan (1982). In these cases, the title “Monetary Authority” was selected deliberately to suggest that the new institutions were not expected immediately either to carry out all the functions or to have the operational independence of a full-fledged central bank.12 In practice, many other central banking institutions in developing countries would be better categorized as transitional central banking institutions than as central banks—despite being called “Central Banks.”

A substantial uniformity in the legislation establishing these transitional central banking institutions should not obscure a considerable diversity of behavior within the category. The legislation provides the transitional central banking institution with responsibilities and executive powers which may be taken up only slowly; a spectrum may be observed from the one extreme of authorities that function virtually as currency boards to the other of authorities that carry out most of the activities of the full-fledged centra] bank.


The case of Fiji provides a good example of the gradual evolution of a transitional central banking institution within a single basic legislative framework. The Central Monetary Authority of Fiji (CMA) has been operating for a decade and over this period has accumulated considerable reserves of technical expertise. It now conducts a wide range of activities and is involved in most aspects of the financial system, which is itself relatively sophisticated relative to Fiji's small size and simple economic structure. The economy is dominated by the performance of the two major exports, sugar and tourism, and is comparatively open to both trade and capital flows.

The CMA is endowed with the sole right of fiduciary issue of the currency, the Fiji dollar, but is restricted by statute to hold external reserves worth at least 50 percent of its demand liabilities and to seek the Minister of Finance's approval for changes in parity. In practice, the CMA has held external reserves at least 100 percent in excess of the statutory minimum, even in the seasonal trough of low foreign exchange receipts, but this has not prevented foreign exchange reserves from falling at times to low levels in terms of months of imports: the need for a sustainable balance of payments rather than any statutory obligations has proven to be the dominant constraint on fiduciary issue. The CMA also exercises discretion over the rates of exchange for the Fiji dollar; these are set each week to fix the Fiji dollar's value against a weighted basket of currencies of trading partners. This system replaces the simple fixed sterling peg anticipated in the legislation.

As banker to the government, the CMA is authorized to grant advances to the government to meet temporary deficiencies in currency revenue, subject to repayment within the six months following the end of the fiscal year, and to hold securities and other debt instruments of the government, provided that the total value of these does not exceed 30 percent of the average annual ordinary revenue of the government. In fact, the government has been, for the most part, a net depositor with the CMA; total borrowing has never exceeded 50 percent of the maximum allowed. This observation remains true when public sector corporations, which are also permitted to bank with the CMA, are included in the analysis. In the past, the Fiji Sugar Corporation in particular, with its strongly seasonal pattern of receipts and expenditures, has made extensive use of this facility; but it is now encouraged to deal directly with commercial banks.

Fiji's banking system consists of five foreign-owned commercial banks and the publicly owned National Bank. Banking legislation requires the former set of banks to obey cash reserve and government security ratio requirements set by the CMA and, in return, the CMA offers lender-of-last-resort facilities. These banks have usually amply exceeded reserve requirements, although the excess fulfillment has tended to fall over time as alternative uses for funds have developed. In response, the CMA has attempted to restrain the rising ratio of loans to deposits through moral suasion, but without complete success. Banks have taken only intermittent recourse to CMA lending, preferring in general to borrow from the parent bank or on the expanding interbank money market. In addition to reserve requirements, banks must obey interest rate, credit allocation, and various other guidelines issued by the CMA subject to government approval. The basis of regulation lies in close liaison with the CMA in regular meetings, rather than a formal inspection which is only authorized at times of crisis.

In addition to the six commercial banks, Fiji possesses a unit trust, a stock exchange, a development bank, an insurance industry, and a credit union movement. The CMA is involved in the management and regulation of these in its efforts to promote the development of the financial system. Particular duties include the underwriting of bonds issued by the development bank and the supervision of the insurance industry, a function that has been recently transferred from the Ministry of Finance.

Despite Fiji's openness, the CMA has been able to follow an active and independent monetary policy, using the various instruments at its disposal. In general, regulated interest rates have been kept low relative to world rates, although not so noticeably low relative to rates ruling in neighboring Australia and New Zealand. This policy is supported by limits on the domestic borrowing of foreign firms and on outward capital flows. The overall strategy is guided by a monetary budget planning procedure in which the CMA has played an important part; its General Manager currently acts as chairman of the main policy-making committee while its Research Department has been closely involved in forecasting exercises.

In sum, although the CMA still has the form of the transitional central banking institution, its operations are becoming sufficiently extensive and discretionary to warrant it the classification of central bank. At present, legislation is being considered to formalize this de facto independence and to amend the original legislation where appropriate. In particular, contemplated measures include the transfer of responsibility for monetary policy decisions from the government to the CMA to simplify cumbersome administrative machinery, the strengthening of powers of bank inspection, and the inclusion of the National Bank under the CMA's aegis.

Maldives and Bhutan

In the newest transitional central banking institutions, in Maldives and Bhutan, the authorities are still much concerned with establishing the national currency as the dominant form of money, a prerequisite to the practice of an independent monetary policy. In Maldives, U.S. dollars—introduced into the economy through tourism—circulate alongside the local currency, the rufiyaa, while time and savings deposits and loans may be denominated in either of the two currencies. The amount of dollars in circulation cannot be measured accurately, making it difficult to monitor developments in domestic liquidity. Moreover, the possibility of dollar deposit and loan accounts would complicate the application of any interest Tate policy intended to separate domestic from world rates. Recent policy, adopted after measures relying on voluntary surrender had proved ineffective, has been to proscribe the use of dollars and other foreign currencies as means of payments. In Bhutan, where the bulk of foreign trade is conducted across an open border with India, the predominant currency in circulation is the Indian rupee, although all bank accounts and contracts are denominated in the national currency, the ngultrum. The Royal Monetary Authority aims to administer a gradual increase in the role of the ngultrum over time, so as not to disturb local confidence in its parity with the rupee. While this shift may be fairly simply accomplished in the interior, the use of rupees seems likely to be more persistent in border areas given the local importance of trade transactions.

Among the first tasks of the authorities in both Maldives and Bhutan has been to assume responsibility for foreign exchange management from various government and other agencies. In Bhutan, matters are complicated by the fact that the bulk of the country's net foreign assets are held in rupee deposits by the country's single commercial bank, the Bank of Bhutan. The Bank of Bhutan is jointly owned by the Government and the State Bank of India, which offers the Bank of Bhutan a preferential return on rupee deposits. For the Royal Monetary Authority to fulfill the function of foreign exchange management effectively, it must obtain satisfactory terms for its own rupee deposits, and be able to manage the business requirements of foreign exchange transactions.

Whether a requirement that the central banking institution hold, say, 50 percent backing for its demand liabilities is more or less stringent than a requirement that it hold 100 percent cover for currency issue depends on the relative demand for currency and deposits in the economy in question.

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

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