Monetary and public debt management are closely linked aspects of economic policy: actions in one area heavily influence the other. At the same time, however, there is a trend toward making the monetary authority—the central bank—more independent of the government, which is the issuer of public debt. This paper discusses the key links between these policies and suggests possible arrangements to reconcile central bank independence with coordination of monetary and public debt management.

Monetary and public debt management are closely linked aspects of economic policy: actions in one area heavily influence the other. At the same time, however, there is a trend toward making the monetary authority—the central bank—more independent of the government, which is the issuer of public debt. This paper discusses the key links between these policies and suggests possible arrangements to reconcile central bank independence with coordination of monetary and public debt management.

Effects of Public Debt Management on Monetary Policy

The volume and characteristics of public debt must be taken into consideration in the formulation of monetary policy. They influence the behavior of the public with respect to money holdings as well as the actions of the central bank.

Public debt can influence the demand for money in at least two ways. First, in the absence of Ricardian equivalence, an increase in the amount of public debt held by residents will have a positive wealth effect, which will tend to increase the volume of real balances demanded.1 Second, liquid government securities can be a substitute for money balances, tending to reduce the demand for such balances. In addition, large outstanding amounts of public debt may create expectations of future inflation, which would also lower the demand for money.

A large amount of public debt will also affect the behavior of the central bank. It can lead to a multiplicity of objectives for the central bank, some of which may be inconsistent with one another. This is particularly the case if the central bank is obliged to ensure that the government debt is financed at a certain cost. Several financing possibilities exist. First, the central bank directly purchases the government debt, thereby expanding base money as the government spends the proceeds of the sale. Second, the debt is placed in the market, but the central bank adjusts its monetary policy stance so as to reduce the cost of market borrowing to the government. Third, the government or the central bank establishes portfolio restrictions that force various economic agents to hold government debt that pays below-market rates.

In the first case, the central bank may try to sterilize the excess supply of reserve money by selling securities in its portfolio or by issuing its own paper. However, this can entail losses for the central bank and consequently cause another expansion of base money when interest payments become due. That will be the case if the sterilization is done through the issuance of central bank liabilities at market rates while the government debt acquired by the central bank carries a below-market rate. The same result obtains if the central bank has to sell at a discount government debt that it purchased at par.

In the second case, the objective of allowing the government to finance the deficit cheaply will often conflict with the anti-inflation objectives of the central bank. The U. S. Federal Reserve pursued such an objective until 1951, when it came to an agreement with the Treasury to stop supporting the price of government bonds. This agreement, called the “Accord” in the literature, was reached so that the high government deficit caused by the Korean War would not lead to a surge in inflation.2

In the third case, the government places restrictions on the composition of the portfolios of certain economic agents—typically pension funds, insurance companies, or financial intermediaries. Pension funds and insurance companies are often required to hold government securities as part of their technical reserves. Liquidity requirements are a common instrument that central banks use to induce banks and other deposit-taking institutions to finance the government.3 Countries as different as Brazil, Cyprus, and India have used this type of instrument extensively.

Insofar as liquidity ratios induce commercial banks to hold government debt, such lending does not appear on the books of the central bank. However, the economic result is equivalent to what obtains when the central bank lends directly to the government but sterilizes the monetary expansion by forcing commercial banks to hold base money (for instance, by raising reserve requirements) or any other central bank liability (for example, central bank securities).4

Both liquidity ratios and reserve requirements are implicit taxes on financial intermediation. Banks obtain a lower yield on their assets than in the absence of such restrictions, which drives a wedge between deposit and lending rates. This creates incentives for disintermediation, as economic agents shift their business to financial transactions that are not subject to those requirements. Domestically, this may involve transferring deposits to nonbank financial intermediaries if these intermediaries are not subject to portfolio restrictions,5 investing the funds in nonintermediated financial assets, increasing currency holdings, or buying nonfinancial assets. Thus, changes in liquidity ratios or reserve requirements will affect relative asset prices. The central bank can make liquidity ratios and reserve requirements more or less burdensome by determining the assets that banks can use to fulfill them. For instance, it can allow a broader set of assets (including, for example, commercial paper) to be counted in fulfillment of the liquidity ratio or it can remunerate deposits held to meet the reserve requirement.

Depending on how burdensome portfolio restrictions are, banks will try to circumvent them. They may package their deposits differently, use off-balance-sheet financing (for example, banker’s acceptances), or set up affiliates—at home or abroad—that can offer financial products that are exempt from such restrictions. Economic agents can also avoid the costs of portfolio restrictions by buying foreign assets. To prevent this, financially repressed economies usually impose restrictions on international transactions. These restrictions always comprise capital account transactions but often also current transactions—since the latter can also serve to facilitate evasion of capital account restrictions.

Portfolio restrictions and interest rate controls are common forms of financial repression. This repression can generate sizable revenue for the government, which largely explains why they have been so prevalent.6 In a recent study, Giovannini and De Melo (1993) compute such revenue for 24 countries. They measure it as the differential between the cost of foreign borrowing and the cost of domestic borrowing, multiplied by the annual average stock of domestic debt. Their estimates exclude central bank holdings of government debt on the grounds that those holdings are financed by issuing reserve money—and therefore are not directly related to financial repression—and that interest paid to the central bank is reflected in the bank’s profits, which typically are transferred back to the government. As shown in Table 5.1, these revenues ranged from zero (in the case of Indonesia) to almost 6 percent for Mexico.7 That paper also suggests a positive correlation between the revenue from financial repression and seigniorage.

Table 5.1.

Size of Revenue from Financial Repression

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Source: Giovannini and De Melo (1993).

The sample for Zaire does not include the years 1981, 1982, and 1983.

Moore (1993) presents evidence on the linkages between portfolio restrictions on banks and fiscal deficits in Mexico. He notes that “as the deficit was approaching its highest levels, the banking system was subject to numerous restrictions that may have been intended to reduce the government’s borrowing cost but that had the unintended effect of crippling bank lending to the private sector” (p. 35). He also finds that elimination of the deficit made it possible to lift restrictions on bank portfolios.

Moore’s results and those of Giovannini and De Melo, discussed above, illustrate an important linkage between central bank policy and fiscal developments. In a country that is heavily dependent on the revenue from fiscal repression, the central bank would have serious difficulties in attempting a financial liberalization unless the government has found a way to make up for the loss of revenue. Moreover, since the revenue from financial repression and seigniorage tends to be correlated, a large fiscal effort will likely be required to compensate for the loss of those two sources of revenue.

Changes in government deposits with the central bank are another important channel through which government operations can have a monetary impact. In many countries, the government keeps its accounts with the central bank. As a result, shifts of funds between the public and the government entail changes in reserve money. Thus, regular government operations, like tax collections and salary payments, result in a sizable sterilization or creation of reserve money that the central bank must include in its monetary programming and offset as appropriate. As discussed later in this paper, in some countries (Canada, Germany, and Malaysia), the central bank manages those balances on behalf of the treasury and can use them as an instrument to attain its monetary objectives. It does so by placing those deposits with commercial banks or with the central bank, depending on whether it wishes to expand or contract the monetary base. In other countries (for example, the United States), special arrangements are in place to minimize the effect of government deposit variations on monetary conditions.

The above discussion focused on the management of domestic public debt. However, the public debt manager also decides how much to borrow domestically and abroad. Other things being equal, borrowing abroad will increase the supply of base money to the extent that government converts the proceeds from the loan into local currency to finance its domestic expenditures. If foreign and domestic bonds are perfect substitutes, this monetary effect will be offset by a corresponding private capital flow. However, this perfect substitutability need not obtain—or its effects may take time—and therefore borrowing abroad will have at least a short-run effect on the supply of reserve money. Moreover, if the institutional arrangements result in the central bank’s assuming the exchange rate risk for foreign borrowing, the central bank may incur heavy losses in case of a sharp depreciation of the currency. If these losses are monetized, a monetary expansion will follow.

Effect of Monetary Policy and Other Central Bank Actions on Debt Management

The above discussion suggests that government financing can have a major effect on monetary policy. In fact, in many countries both in the industrial world (for example, Italy) and in the developing world (for example, Argentina and Brazil), it has been the key influence.8 In turn, monetary policy and other central bank actions affect debt management. These effects may not be easy to predict. For instance, an expansionary monetary policy will normally facilitate the placement of government debt. However, if it leads to inflation, different results may obtain. The government will have to adjust the yield on its paper to take inflation into account, either through indexation or through a nominal interest rate that compensates investors for expected inflation. Sometimes, the government may be unable to adjust the yield on government debt because of legal caps on interest rates—assuming of course that the cap also prevents the government from selling its paper below par.

In addition to the stance of monetary policy, the central bank’s choice of instruments for its monetary operations can affect the government’s debt management. Government securities not only serve to finance the budget but also often serve as a monetary policy instrument. Central bank participation in the market will make that paper more liquid and hence will reduce the government’s borrowing cost. The coordination issues raised by the use of securities both to finance the government and for monetary operations are discussed later in this paper.

The design of a central bank rediscount facility can affect the demand for government debt. Often, a central bank will be prepared to rediscount government paper or to accept it as collateral for its loans. In particular, if it accepts government paper under better conditions than private paper (and even more if the latter is not accepted at all), it lowers the borrowing cost of the treasury with respect to that of the private sector (beyond what could be justified owing to the lower risk of government securities). Moreover, government paper that meets the requirements set by the central bank to accept it in its operations—for example, the paper’s maturity—will tend to bear a lower yield than government paper that is ineligible for those operations. This will influence the choice of security characteristics that a cost-minimizing government debt manager makes.

Many central banks have issued their own securities to implement monetary policy. Those papers will typically compete with those issued by the government to finance itself and will tend to raise government borrowing costs.

The design of other central bank instruments also influences the demand for government debt management. For instance, reserve requirements will have different effects, depending on whether reserve balances must be maintained as an average or on a daily basis. In the former case, if the requirement is high, the stock of reserves is likely to suffice to meet a bank’s liquidity needs as they may result, for instance, from the interbank settlement. Therefore, banks have less need for other liquid assets, such as government bonds that they can easily liquidate or use as collateral to obtain reserve money, than would be the case if the requirement had to be met on a daily basis. In the latter case, a bank cannot use its reserve balances to cushion changes in its liquidity needs.

Whether the reserve system is contemporaneous or lagged also has a strong influence on the demand for liquid paper. Under a contemporaneous system, commercial banks must adjust their reserve balances during the same reserve-maintenance period in which their deposit liabilities changed. Under a lagged system, banks have some scope to postpone adjustment or to adjust more gradually—depending on their expectations and when during the reserve-maintenance period the change occurred. Whether the reserve system is contemporaneous or lagged will also affect banks’ preferences regarding holdings of liquid government debt. Other things being equal, banks will wish to hold a more liquid portfolio under a contemporaneous reserve requirement system than under a lagged one, and, therefore, will tend to hold a larger share in liquid government securities.

The central bank also affects the functioning of the money market, a major influence on the market for government debt. For instance, it may have established special arrangements, such as having designated a group of dealers as primary dealers, setting obligations for them, and giving them certain privileges. A typical obligation for these dealers is to quote buy and sell prices constantly for government securities, which enhances the liquidity of those securities.

In addition, the central bank either operates or regulates payments systems, whose arrangements also have a bearing on the demand for government debt and on the terms and conditions of government paper. A reliable, low-cost, and fast payments system for large-value transactions will facilitate the growth of the money market, including the market for government securities. Such large-value systems usually include mechanisms for the transfer of the securities that often are the counterpart of a transfer of reserve money.

In countries having capital controls, it is often the central bank that sets them. These controls (for example, special deposits established to equalize domestic and foreign borrowing costs) will also affect the borrowing costs of the government and will influence the debt manager’s decision regarding where to borrow.

Finally, some central banks also manage or regulate deposit insurance schemes. These schemes can affect the demand for government debt. First, by making deposits safer, deposit insurance can make them closer substitutes of government securities for investors seeking safe assets. Second, if the scheme is funded and contributions are invested in government bonds, the demand for those bonds will tend to increase.

Case for Central Bank Independence

Recently, interest in central bank independence has increased. Papers and books dealing with the subject have been appearing at a fast rate. Many countries are adopting or revising legislation aimed at increasing central bank independence.

Central Bank Independence in the Economic Literature

What is central bank independence? How can it be measured? What can it achieve? These are the key questions that the literature has tried to answer. The empirical and the theoretical literature have followed different approaches in dealing with these issues.9

Empirical studies have focused on identifying certain attributes of independence, designing indicators to measure them, choosing a policy objective—such as inflation, growth, or the government deficit—and then comparing how countries whose central banks have different degrees of independence compare with one another in terms of attaining the chosen policy objective.

Those studies have considered various attributes of central bank independence, such as financial independence and political independence. The former has been measured by indicators such as the central bank’s ability to set salaries for its staff, to control its budget, and its degree of discretion regarding distribution of its profits. Financial independence, particularly in many developing countries, should also include the freedom for the central bank not to undertake operations that will lead to central bank losses. For instance, in the 1980s in several Latin American countries (such as Argentina, Chile, and Uruguay), central banks had to bail out commercial banks and provide exchange rate guarantees that proved to be costly.10

Political independence indicators have included such features as whether the government appoints the members of the bank’s council, government representation in that council, and who has final authority—the government or the bank—in policy matters in the central bank’s jurisdiction. To pass judgment on the degree of central bank independence, some authors have devised composite indices, which incorporate several of the above attributes.11 The provisions of the central bank law have been a key criterion for gauging those attributes; other factors, such as the turnover of central bank governors, have also been considered.

Price stability has been the policy objective that most economic studies have considered. This stance reflects the view that inflation is a monetary phenomenon. Thus, the test aims to determine whether an independent central bank is better able to keep inflation low than a central bank that is not independent. Several studies fall in this category: Bade and Parkin (1985); Alesina (1988); Grilli, Masciandaro and Tabellini (1991);

Cukierman (1992); and Cukierman, Webb, and Neyapti (1992). The first three cover member countries of the Organization for Economic Cooperation and Development (OECD) only; the last two cover 72 countries throughout the world. All these studies find evidence of a negative correlation between inflation and the degree of independence—one of them also found a negative correlation between the variance of inflation and central bank independence (Alesina and Summers, 1993).

Studies on the relationship between economic growth and central bank independence have yielded less conclusive results. Grilli, Masciandaro, and Tabellini (1991) and Alesina and Summers (1993) found no correlation between central bank independence and economic growth. The results in these papers are somewhat puzzling, as evidence for essentially the same set of countries suggests a negative correlation between inflation and growth (Grimes, 1991), and as discussed above inflation has exhibited a negative correlation with central bank independence. However, De Long and Summers (1992) observed a positive correlation between the growth rate of real GDP per worker and central bank independence.

An interesting insight regarding industrial and developing countries comes from the analysis of Cukierman and others (1993), who found no correlation between central bank independence and economic growth for industrial countries but a negative correlation for developing countries. This may be related to the fact that independence has been higher for industrial countries as a group than for developing countries. Thus, beyond a certain (high) degree of independence, more independence seems to make little difference for economic growth.

Finally, a few studies have addressed the relationship between central bank independence and fiscal deficits. Parkin (1986) found a negative correlation between the two. Masciandaro and Tabellini (1988) had inconclusive results: despite the high degree of independence of the Federal Reserve, the United States showed fiscal deficits of the same order of magnitude as countries whose central banks are much less independent.12 Grilli, Masciandaro, and Tabellini (1991) analyzed 18 OECD countries during 1950–89. They observed a negative correlation between central bank independence and fiscal deficits. However, that correlation disappeared once political factors—related to government stability—were taken into account.

Pollard (1994) finds a negative, but statistically not significant, correlation between central bank independence and fiscal deficits. Furthermore, she reports a negative correlation between the former variable and the variability of fiscal deficits.

The theoretical literature has defined independence using a criterion somewhat different from those used by the empirical literature, as discussed above. Rather than focusing on issues such as the governance and the financial autonomy of the central bank, it has defined independence as a lack of cooperation between the fiscal and the monetary authorities. Thus, an autonomous central bank is one that sets monetary policy without regard for the fiscal authority’s objectives. Moreover, this literature assumes that the behavior of the fiscal and the monetary authorities results from the minimization of different loss functions, including growth and inflation. The assumption is that, in their loss functions, the fiscal authority will tend to give more weight to growth than the monetary authority and that the opposite holds for inflation.

The papers of Pyndick (1976), Andersen and Schneider (1986), Alesina and Tabellini (1987), Petit (1989), and Hughes Hallet and Petit (1990) follow the lines discussed above. These studies conclude that noncooperation is suboptimal. Policy conflicts between the central bank and the fiscal authority result in lower growth and higher inflation than what would obtain under cooperation.

Of particular interest for this paper are some theoretical studies that focus on the effect of central bank independence on government debt.13 The argument starts with the assumption that the government cannot indefinitely accumulate debt to finance itself. Thus, the issue is whether a policy of high deficits will eventually force the central bank to monetize part of that debt, causing inflation and reducing the outstanding value of the debt. These studies also show that cooperation yields better results in terms of lowering the value of the debt.

From the above, it appears that the empirical literature and the theoretical literature have reached different conclusions on the benefits of central bank independence. The former finds independence advantageous, and the latter disadvantageous. This need not entail a contradiction. The empirical literature defines independence differently from the theoretical literature. The former focuses on the ability of the central bank to be outside the direct influence of the government. The latter equates independence with lack of coordination. Thus, the contradiction between these two strands of the literature disappears, for instance, if a central bank is independent of the government politically and financially but its objectives agree with those of the government.14

Central Bank Independence Experiences

As noted earlier, many countries have endeavored to grant more independence to their central banks. Such independence has been interpreted as the ability of the central bank to design and implement monetary policy without interference from other government bodies. The argument behind these efforts rests on two premises. First, monetary policy can be effective in achieving price stability. Second, such a policy can be better implemented by an institution that is not subject to the daily political pressures that the government faces.

The member countries of the European Union have undertaken to give their central banks a high degree of independence. Under the Maastricht Treaty, central banks cannot receive instructions from the government, and their governors have a minimum term of five years, which can be extended. Moreover, the treaty has strict provisions regarding credit to the government. In particular, its Article 104, which discusses credit to the government from the European Central Bank (ECB) and the member countries’ central banks, specifically states:

1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favor of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

However, the treaty still allows central banks to purchase government debt instruments in the secondary market. The treaty has prompted a revision of central bank legislation in Europe to comply with the treaty’s provisions.

Countries in other parts of the world have also adapted their legislation to make their central banks more independent. New Zealand and several countries in Latin America are examples of this movement. New Zealand’s legislation, which took effect in February 1990, is often cited as a model in this regard. The old legislation it replaced was typical of central bank laws passed until the 1980s. It provided for the central bank to maintain and promote social welfare; to promote trade, production, and full employment; and to maintain a stable internal price level. The relative importance of these objectives changed over time, depending on circumstances and the views of the government in power.15

The multiplicity of objectives that the law gave to the Reserve Bank of New Zealand prevented it from focusing on any of the objectives.

Moreover, government policies up to 1984 led to large fiscal deficits and a rapidly growing public debt (Charts 5.1 and 5.2). Domestic public debt was placed with the Reserve Bank and, compulsorily, with the rest of the financial system. Interest rates and the lending of financial institutions were strictly controlled. Pervasive exchange controls had little effect on large external deficits, and foreign debt was growing rapidly. An interesting feature of the change in the Reserve Bank’s Act was that it came after the government had embarked on liberalization and had, in practice, granted more autonomy to the Bank.16

Chart 5.1.
Chart 5.1.

New Zealand: Domestic Public Debt

Percent of GDP

Sources: International Monetary Fund (1992, 1993). (Information for 1989 is unavailable.)
Chart 5.2.
Chart 5.2.

New Zealand: Fiscal Balance

percent of GDP

Sources: International Monetary Fund (1992, 1993). (Information for 1989 is unavailable.)

The reform of the law focused on giving a clear, single objective to the Bank’s policy—price stability—and on ensuring transparency and accountability. Transparency is ensured by the Policy Targets Agreement, signed by the Minister of Finance and the Governor of the Reserve Bank, which establishes performance criteria for the Governor to meet under his or her contract. This agreement sets forth the inflation target that the Bank must pursue and indicates when it must be attained. It also includes certain caveats, such as changes in indirect taxes or in the terms of trade, which would provide for a renegotiation of the terms of the agreement.

The terms of the policy targets are made public, and the Bank is also required to issue a public statement every six months, outlining its policy and discussing past monetary developments.. While the law makes price stability the sole focus of central bank policy, as an exception it allows the government to direct the Reserve Bank to pursue a different economic objective for a maximum period of 12 months, which can be extended

Other provisions of the Reserve Bank’s law aim at providing accountability. For instance, the Minister of Finance and the Governor also sign a funding agreement, which establishes the maximum amount that the Bank can spend over the five-year duration of that agreement. The Governor is personally responsible for the achievement of the targets set forth in the Policy Targets Agreement. A board of directors exists but has no power to set policies; its main role is to monitor the Governor’s performance under the Policy Targets Agreement. Unjustified failure to fulfill the agreement provides grounds for dismissing the Governor.

Thus, New Zealand’s law affords great independence to the central bank but only to pursue a specific objective, which, in addition must be set in agreement with the government.17 Also, the government has the power—which it has not yet exercised—to direct the Bank to follow a different objective. However, it must make such a directive explicit and public, which is likely to make it politically costly.

A final point about the reform of the Reserve Bank legislation is that it did not occur in a vacuum: the government had already granted de facto independence to the central bank, and a stabilization and liberalization program had been implemented. Thus, the legislative changes were meant not to increase such independence but to make it more permanent by including it in the law.

As noted earlier, several countries in Latin America have reformed their central bank legislation or are planning to do so.18 The following countries recently introduced changes in their central bank legislation: Argentina (1992), Bolivia (1993), Chile (1989), Colombia (1992), Ecuador (1992), El Salvador (1991), Mexico (1993), Nicaragua (1992), and Venezuela (1992). Others are in the process of changing legislation: these include Costa Rica, the Dominican Republic, Guyana, Paraguay, and Uruguay.19

These legislative reforms aim at minimizing the potential for central banks to be pressured to adopt policies that undermine price stability, as was often the case in the past. Central banks in Latin America financed public sector deficits and undertook various quasi-fiscal activities, which in the end fueled inflation. Those activities have included, among others, financing the government at below-market interest rates, directing credit and granting interest subsidies to specific sectors, extending exchange rate guarantees—which entailed significant losses for the central bank when they had to be honored—assuming responsibility for exchange risk on external borrowing, administering multiple exchange rate arrangements, and funding poorly designed deposit insurance schemes.

As was the case in New Zealand, the legislative reform in Latin America was most often part of a package of measures aimed at attaining monetary stability. Furthermore, again as in New Zealand, the idea was not to reform the law so that a stronger central bank could attain stability but rather to protect the central bank from political interference in the future, so that stability could be better preserved. This protection against future mismanagement yielded the immediate benefit of greater credibility in the policies that were being implemented. The experiences of Chile and Argentina illustrate this general point.

In Chile, the 1980 constitution already included the principle of central bank autonomy. The objective was to prevent a recurrence of the old practice of monetization of fiscal deficits. A new draft central bank law was prepared in 1981, but the 1982–83 crisis caused the project to be shelved until 1986.

The law finally came into effect in October 1989, after the economy had recovered from the crisis and resumed rapid growth in a context of abated inflation. Moreover, the nonfinancial public sector balance had turned to surplus in 1988 and has remained in surplus since then.

In Argentina, discussions about reforming the central bank law began in 1989, when inflation had reached an annual rate of almost 5,000 percent and the nonfinancial public sector deficit was equivalent to about 12 percent of GDP. However, the reform project languished as the government tried to cope with an extremely difficult economic situation. It was put back on the agenda only after a successful stabilization program—which had started with a strong fiscal adjustment in 1990 and continued with the passage of the convertibility law in April 1991—was firmly in place.

The convertibility law committed the central bank to buying and selling foreign currency at the exchange rate of ARG$1 = US$1 and to maintaining at all times an amount of freely usable international reserves20 equivalent, as a minimum, to 100 percent of base money. Thus, even before reforming central bank legislation, Congress limited the powers of the central bank through the convertibility law to increase domestic credit by lending to the public sector or to banks.

The central bank law was finally adopted in October 1992 and incorporated the changes required to make it fully consistent with the convertibility law.

Swinburne and Castello-Branco (1991) review the experience of eight countries in addressing central bank independence. They reach several important conclusions.

First, for both practical reasons and reasons of constitutional principle, it is not helpful to think of the ultimate responsibility for monetary policy lying anywhere else than with the political leadership. . . . Second, … central bank autonomy needs to be accompanied by effective monetary policy accountability. . . . Third, clear, nonconflicting objectives and a structure of incentives and sanctions that align the motivations of the central bank, as monetary policy agent, with what is considered to be welfare-maximizing monetary policy, are important requirements. . . . Fourth, for similar reasons, the respective roles of the central bank and the political authorities need to be clearly set out, and the relationships between the two need to be transparent and consistent. . . . Fifth, if there are conflicts and trade-offs inherent in a central bank’s functions, monetary policy independence and credibility might, in the extreme, require reconsideration of the mix of functions allocated to the central bank. . . . Finally, it is worth noting that central bank independence by itself cannot guarantee monetary policy credibility (1991, pp. 443–44).

Central Bank Independence and Coordination

The discussion in the first two sections of this paper suggests that monetary policy and debt management are closely linked and that some other activities typically carried out by central banks, such as the operation of the payments system, have a heavy influence on debt management. Moreover, government debt instruments play a major role in the implementation of both fiscal and monetary policy. These factors argue for coordination between the central bank and the institution in charge of debt management.

At the same time, the discussion in the next two sections summarizes the growing trend to make central banks independent, in order to allow them to focus on achieving price stability, which is perceived as the main objective of monetary policy. How can these seemingly conflicting aspects be reconciled? What degree of coordination is appropriate for an independent central bank? Can some lessons be drawn from recent experiences?

Policy Coordination Issues

Subordinating monetary policy to the financing of the budget in the face of high fiscal deficits will lead to high inflation. The experience of the United States before the 1951 accord and the experiences of countries in Latin America, among others, support this view. At the same time, as a practical matter, success in bringing down inflation and focusing the central bank on stabilization cannot rely solely on legislation that makes the central bank independent. Rather, support for stabilization must be broadly based to maintain such independence and preserve macroeconomic stability. It is no coincidence that initiatives to make central banks independent were often preceded by episodes of high inflation.

Limiting government access to central bank credit can help in avoiding inflationary financing.21 Leone (1991) finds a close positive correlation between lending to the government and growth in reserve money. An important issue is determining what types of central bank credit to the government should be constrained. Cottarelli (1993) argues that overdrafts should be prohibited in countries with developed financial markets, as they make base money creation dependent on the government cash flow and provide the central bank with an unmarketable instrument. He also suggests that “purchases of government paper on the primary market may also be banned to strengthen the formal separation between the government and the central bank.” 22 However, he argues that purchases of government securities in the secondary market need not be constrained. For cases in which markets are less developed, he suggests that some limited automatic access to central bank credit may be appropriate. He also notes that indirect credit may have to be constrained if there is a danger of its being used to circumvent limitations on direct lending. Table 5.2 below shows the way in which limits have been set in a sample of 57 countries.23

Table 5.2.

Regulation of Central Bank Credit to the Government by Type of Credit

(Percentage composition)

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Source: Cottarelli (1993, p. 33).

Leone (1991) introduces a note of caution on the effectiveness of legal limitations on central bank lending to the central bank. After analyzing data for 22 developing countries and 22 industrial countries, he concludes that in the presence of large deficits, ways are likely to be found to circumvent such limitations.

Coordination on Debt Issuance

The fiscal and monetary authorities should agree on certain objectives regarding debt issuance. First, a program of debt sales must be based on a sound fiscal strategy. If the public believes that the burden of public debt will cause the debt to be repudiated or monetized, the perceived risk and inflationary expectations will rise and, at a minimum, raise borrowing costs to the government. Second, the primary issuance of government debt should be voluntary—that is, market placements with flexible and competitive interest rate determination—rather than based on captive markets using statutory reserve and liquid asset requirements and interest rate restrictions.

Third, the central bank and the ministry of finance should decide whether to use the treasury bill sales program only to finance part of the fiscal deficit and smooth out short-term fluctuations in treasury cash flows (a debt-management objective) or to also use it for monetary management. In either case, a joint committee (or working group) of central bank and finance ministry officials can serve to discuss the features of primary issues. If primary issues are mainly intended for deficit financing, the central bank should serve as an advisor, especially in the planning process, but final authority should rest with the ministry. If primary issues are also used for monetary policy purposes, the central bank must have much greater discretion in choosing the volume of securities to issue.24 If the central bank uses primary issues of government securities for monetary operations, topics such as the remuneration of government balances held with the central bank require special consideration. The ministry of finance will generally be reluctant to issue securities—and pay interest on them—simply to have the proceeds held in unremunerated accounts with the central bank.25 It may insist on having those balances remunerated at a market rate of interest (for example, at the same rate that it pays on the securities it issues).

Often, the central bank and the treasury will have different preferences regarding the types of paper they wish to use. Central banks tend to use only short-term paper in their operations, while treasuries, taking into account the expected pattern of their cash flows and expected movements in interest rates, use a mixture of debt maturities.

Some central banks have resorted to issuing their own securities to carry out monetary operations. Table 5.3 presents some examples.

Table 5.3.

Debt Securities Issued by the Central Bank—Practices in Selected Countries

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Source: Sundararajan and others (1993).

The issuance of central bank paper for monetary operations has the advantage of giving the central bank more flexibility in deciding the volume of sales and in tailoring the characteristics of the paper to the preferences of the market. It has the disadvantage of introducing yet another security in the market, which competes with the treasury issues. Moreover, a proliferation of different securities will make the market for each one of them thinner and, therefore, less attractive to the public.

Although the central bank needs to have flexibility in determining the volume of its open market operations, it is important for the issuer of government debt to know the central bank’s broad plans in this area—for instance, expected monetary developments and the likely size of central bank intervention. This would give the government debt manager a better idea of the market’s capacity to absorb additional government debt.

Management of Government Deposits

As noted earlier, movements in government balances with the central bank can have a powerful monetary effect, sterilizing or expanding reserve money. Sales of government paper in the primary market are just one cause of such movements. Tax payments, payments for government purchases, and government salaries are other forms. These factors can introduce large variability in reserve money balances if payments into and out of government accounts are lumpy. They can disrupt money markets and also make the exchange rate volatile under a regime of flexible exchange rates.

At a minimum, the central bank needs to have advance information on expected government cash flows to be able to manage their monetary effects. Some countries have gone further and established specific arrangements to deal with those effects and events to use them as a tool of monetary management. Table 5.4 presents examples of such arrangements.

Table 5.4.

Arrangements for Dealing with Variations in Government Cash Balances in Selected Countries

article image
Source: Sundararajan and others (1993).

Information and Operational Issues

To implement monetary policy properly, the central bank needs information on the timing and intended amount of government debt issues and, in general, on the cash flow of the government—particularly if the flow involves sterilization or creation of reserve money. Practical arrangements for coordination vary: they might involve participation of both treasury and central bank representatives in special committees that meet periodically to discuss the policy intentions of these two institutions and informal daily consultations to discuss expected changes in government balances with the central bank. The former allows the two institutions to set out their broad policy objectives and to review plans for debt issuance and medium-term perspectives. The informal consultations help the central bank plan its daily money market activities.

The central bank needs to work closely with other market participants and with the treasury in organizing a system for the transfer and payment of securities. Appropriate design can make government securities more liquid and reduce the risks of security transactions. This will make them more attractive assets and thus lower the costs for the government. In countries in which the central bank manages the issue of treasury paper, it also operates the debt registry. The efficiency of this registry is a key element for debt-management operations. It must suit the needs of the borrower (the government), the lenders (the holders of government debt), and the market operators.

The Central Bank as Fiscal Agent

In many countries, including most of Latin America, the central bank, in its role as fiscal agent, has a great deal of influence on public debt management. This helps coordination but may sometimes lead to a conflict of interest between the bank’s duties as monetary authority and its duties as fiscal agent; in case of conflict, the central bank is likely to give priority to its duties as monetary policy authority. The arrangements discussed above, in fact, allow for coordination to proceed without necessarily having the central bank vested with the responsibility of managing public debt on behalf of the treasury.

The arrangements that are appropriate for a particular country are likely to change over time. For instance, the Bank of Canada, acting as fiscal agent, used to exercise a lot of influence on debt-management policy. However, the Ministry of Finance took a much more forceful role in debt management after the mid-1980s so as to concentrate more on cost minimization in the management of the public debt.


Monetary policy and public debt management are closely linked components of economic policy. Sales of public debt have important monetary effects and can be a key instrument in the implementation of monetary policy. Also, the monetary policy stance, the set of instruments used by the central bank, and other central bank operations have a direct bearing on the cost of government borrowing. These facts argue for close coordination of monetary policy implementation and debt management.

At the same time, there are important reasons for granting the central bank independence in its pursuit of monetary policy. Although there are difficulties in quantifying the advantages of having an independent central bank, evidence suggests that an independent central bank has a better chance of implementing a monetary policy conducive to price stability. Moreover, a number of countries have reformed their legislation to enhance the independence of their central banks, giving them a clear objective—price stability—and ensuring that they are accountable.

Therefore, the issue of how to coordinate monetary policy with public debt management arises in a context in which responsibility for these two aspects of economic policy implementation is vested in two different institutions, the central bank and the ministry of finance. Coordination requires, first, that the objectives of the fiscal and the monetary authorities be compatible. An independent central bank will be hard pressed to achieve its price stabilization objective without the support of the ministry of finance. Second, the two parties should have a clear understanding of the objectives of debt issuance. This requires deciding how large a fiscal deficit can be financed through this mechanism, what fraction of the debt will be placed abroad, and whether domestic primary issues will be used to implement monetary policy or whether the central bank should issue its own securities for that purpose. Ideally, they would also agree on a strategy for developing the market for public debt securities and the money market.

The central bank law will typically include restrictions or a strict prohibition on central bank direct lending to the government that provides a framework for the financial relationships between the bank and the government. Other issues that need to be addressed include the distribution of central bank profits as well as mechanisms to provide for central bank recapitalization in case of losses. Table 5.5 presents information on arrangements on the treatment of central bank profits and losses for a sample of countries. Finally, there will be a need for a frequent exchange of information between the two institutions, particularly to ensure that fiscal operations do not have unintended monetary consequences.

Table 5.5.

Treatment of Profits and Losses in a Sample of Countries

article image
Source: Sundararajan and others (1993).

Brazil’s central bank has assumed, however, a large foreign debt portfolio that reduces its profits substantially, as foreign exchange valuation adjustments are charged against profits.

Various institutional arrangements, either formal or informal, can be designed to achieve those purposes. The agreement signed between the Minister of Finance and the Governor of the Reserve Bank of New Zealand is an example of a formal arrangement. A coordination committee comprising high officials of the ministry of finance and the central bank is an example of an informal arrangement used in many countries. In addition to a coordination committee, there should be frequent informal contacts between working-level staff of central banks and ministries of finance to stay abreast of day-to-day developments. Finally, specific arrangements to deal with the monetary effects of shifts of government deposits can be helpful.

In sum, central bank independence need not jeopardize appropriate coordination between the institutions responsible for monetary policy and debt management. On the contrary, by keeping these institutions well focused on their responsibilities, such coordination can be enhanced if appropriate arrangements are put in place to make the goals of both institutions consistent and to exchange information.


Roberto Junguito

In the first section of his paper, which deals with the effects of public debt management on monetary policy, Baliño analyzes the forms through which public debt can influence the demand for money, as well as the monetary impact of central bank behavior as manifested in its reactions to a large amount of public debt.

His discussion, however, deals exclusively with domestic public debt. My major comment, in this regard, is that the author does not analyze the monetary impact of sovereign external debt, given alternative exchange rate policies and sterilization efforts on the part of central banks. If the government or the central bank had any kind of real exchange rate targeting, it would be found that a higher external public debt would lead to an increase in base money owing to the additional flow of international resources. The central bank’s most probable reaction would be to attempt to sterilize base money through higher interest rates in its open market operations. As the Colombian experience of 1991 showed, this exercise may be frustrating to the extent that it stimulates capital inflows and has severe quasi-fiscal losses.

By the same token, if the government places its debt domestically, it can do it only by increasing interest rates or at the cost of lowering the holdings of the central banks’ papers in its open market operations. In both cases, there may also be a monetary impact. If interest rates rise, they could provoke the monetization of increased capital inflows owing to the differential interest rate. In the second case, the central bank would be forced to reduce its placements of paper through open market operations.

In terms of the reaction of central banks to public sector indebtedness, Baliño tends to portray the figure of a concessional central bank attitude toward increasing the government’s fiscal deficits. This is not so. The new independent central banks in Latin America have established limitations and prohibitions for extending credit to the government. This is true in Argentina, Chile, Mexico, and Venezuela. In Colombia, unanimity of the board of directors is required. This reduces the direct monetary impact of government debt.

In the same vein, it should be pointed out that in regard to the alternative ways to finance governments cheaply that Baliño described, they are no longer common in Latin America given that the new independent central banks have also attempted to limit indirect ways to finance the government and because ongoing financial reforms have tended to eliminate all sorts of forced investments and interest rate subsidies.

A different type of comment regards Baliño’s estimations of financial repression. If the exercises to measure financial repression were to be applied today, contrary to his results, their results would indicate either low or negative repression indexes. In fact, owing to capital inflows, exchange rates in Latin America have been appreciating. Domestic interest rates, if anything, are higher than international interest rates adjusted with exchange rate changes.

In regard to the second part of Baliño’s paper, which analyzes the effects of monetary policy and other bank actions on debt management, the author illustrates a number of central bank monetary policy actions that have an impact on public debt management and that lower the cost of government placings: central bank participation in the market with government bonds makes such papers more liquid; the design of a rediscount facility; the design of reserve requirements; the regulation of the payments system; and the regulation of deposit insurance.

There are, in contrast, clear cases not mentioned by Baliño where central bank actions have the opposite effect: they make public debt management more difficult, for example, when the bank places its own securities in the market in an effort to exercise monetary restraint and interest rates rise, and whenever the central bank fixes strict minimum financial (solvency) conditions for public enterprise bond placements.

The author also ignores the impact of foreign exchange regulations and exchange rate policies of the central bank on public debt management. Nowadays, independent central banks in Latin America may restrict public indebtedness by exposing the government to exchange rate risks. Some banks also have the authority to establish capital controls. A case in point is the foreign exchange deposit established in Chile and Colombia, whereby foreign and domestic interest rates are equalized.

To finish my comments, I would like to refer to the last section of the paper, which discusses the case for central bank independence. Baliño develops the arguments found in the economic literature in favor of central bank independence and describes the experiences, including the more recent ones, of some Latin American countries. To begin with, it is worth nothing that Argentina, Chile, Colombia, and Venezuela have introduced central bank independence in the past few years; that Mexico has approved the constitutional changes for introducing an independent central bank; and that it has also been discussed in Bolivia, Ecuador, and Peru.

Also, I would like to emphasize that the institutional changes undertaken have been significant and that the new independent central banks in Latin America are among the most independent banks in the world. Colombia, in terms of the Cuckierman Index, can be classified in fourth place, and Chile would be ranked even higher.

There is also evidence that independence is not simply formal but operational. The relatively new experience also indicates that central bank independence has been key to the adoption of macroeconomic policies that have contributed to the lowering of inflation at least in Chile and Colombia.

The issue then is not so much to discuss the merits of central bank independence in Latin America but to foresee the challenges that the new central banks face in order to guarantee their survival. They may be summarized in four points:

  • (1) The loss of monetary independence with the elimination of capital controls. Monetary policy is the principal instrument assigned to central banks to lower inflation.

  • (2) The pressures to backslide in stabilization efforts when anchoring the exchange rate result in severe real exchange rate appreciation.

  • (3) The limited capacity that central banks have in terms of persuading government to reduce public expenditures and fiscal deficits.

  • (4) The coordination issues with the government, especially with the incoming administrations that may not share the priority that should be given to price stability and that are not committed to the idea of having an independent central bank.


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Note: The views expressed in this paper are those of the author and do not necessarily reflect the views of the International Monetary Fund. Comments received from Messrs. Carlo Cottarelli, Ernesto Feldman, David Hoelscher, from the two discussants (Messrs. Roberto Junguito and Sérgio Ribeiro da Costa Werlang), and from other participants of the seminar are gratefully acknowledged.


For a discussion of this issue see Tanner and Devereux (1993). They suggest the possibility-that a positive correlation between public debt and real money balances might reflect a supply rather than a demand effect. They argue that if public debt is monetized but the public adjusts its money holdings with a lag, then such a correlation might be observed. For the United States, however, they find evidence of a demand but not of a supply effect.


For an excellent discussion of this episode, see Friedman and Schwartz (1963).


This instrument has also been viewed as a prudential tool, to ensure that those institutions are able to meet their obligations. However, modern prudential criteria focus on the overall liquidity position of an institution (that is, including all assets and liabilities as well as off-balance-sheet items) and do not rely on mandatory minimum ratios.


Which instrument the central bank chooses is not trivial, owing to differences in the remuneration among them.


For instance, in Cyprus deposits with credit cooperatives as a share of total deposits rose from less than 25 percent to about 33 percent between 1983 and 1992. At least in part, this shift was due to the imposition of a liquidity ratio on banks but not on those cooperatives. This allowed the latter to gain market share gradually, as they could offer better rates to their clients; this process tapered off as the fall in international interest rates began to be felt in Cyprus.


In addition to misguided efforts to provide cheap finance to certain sectors.


Owing to differences in data availability, the sample periods differ and their length is not uniform.


The same can be said of most transforming centrally planned economies in Eastern Europe and in the former Soviet Union.


For a good survey of this literature, see Pollard (1993).


These cases and some other financial crises are discussed in Sundararajan and Baliño (1991).


Bade and Parkin (1985); Alesina (1988); Grilli, Masciandaro, and Tabellini (1991); and Cukierman, Webb, and Neyapti (1992) constructed such indices. Alesina and Summers (1993) used the average of the indices of Bade and Parkin, and Grilli, Masciandaro, and Tabellini as their measure of central bank independence. For a good summary of their results, as well as for a discussion of the general issue of central bank independence and economic performance, see Pollard (1993).


The first of these studies covered all OECD countries during 1955–83. The second covered only Australia, Canada, Japan, New Zealand, and the United States during 1970–85.


The cases of New Zealand and Argentina, discussed below, are examples of countries that have independent central banks, but the policies that these banks can follow are constrained. In the case of New Zealand, the constraints arise from the explicit agreement between the Ministry of Finance and the Governor of the Reserve Bank on the inflation target. In the case of Argentina, they are embodied in the Convertibility Law, which requires the central bank to follow policies and use instruments that are consistent with the goal of preserving the peso-dollar parity set by the law.


For a description of the motivation and contents of the new central bank law for New Zealand, see Knight (1991).


As will be discussed below, this has also been the case in other countries that have recently reformed their central banking legislation.


This represents an interesting way to reconcile the different views on independence espoused by the empirical and the theoretical literature on the subject. The central bank has full political and financial independence and also decides how to pursue its objectives. The objectives, however, are the result of an agreement with the government.


The following discussion on central banking reform in Latin America relies heavily on Dueñ (1994).


Bolivia and Ecuador are studying further amendments to their central bank legislation.


This concept is similar to gross international reserves. However, it includes foreign-currency-denominated securities issued by the treasury and excludes the foreign currency deposits that commercial banks must hold with the central bank in fulfillment of the reserve requirements on foreign currency deposits.


For a detailed discussion of the rationale for this limitation, see Cottarelli (1993).


Ibid, p. 26.


Detailed information on individual country arrangements is presented in Cottarelli (1993), Appendix III.


If there is a developed secondary market, central banks usually prefer to use it for their monetary operations. However, many central banks have used sales in the primary market as a substitute in the absence of sufficiently developed secondary markets.


Sales of government securities serve a monetary purpose only to the extent that the sales proceeds are not spent.

The Latin American Experience: Proceedings of a Conference held in Mangaratiba, Rio de Janeiro, Brazil, March 16-19, 1994