The rationale of central banking has been argued too exclusively in terms of monetary policy and control of the financial system even though historically and logically its role in the development of the financial system precedes control. A central bank is commonly seen in terms of its traditional functions as issuer of currency, government’s banker, banker’s bank, controller of credit, and a lender of last resort. But it can also be viewed as a developer of the financial system and promoter of economic development. This article analyzes the developmental role of central banks and the problems of harmonizing it with their monetary, regulatory, and prudential functions.
Central bank objectives may be broadly classified into (1) the tactical or conjunctural objectives of short- or medium-term monetary stabilization, and (2) the strategic or developmental objectives. Conjunctural objectives are spelt out in central bank statutes in both developed and developing countries, whereas the developmental objectives normally are stated explicitly only in the statutes of developing country central banks. The US Federal Reserve Act is one of the few developed country exceptions. This Act enjoins the Board of Governors and the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” (Section 2 A. 1). It also requires that the Board of Governors should act “in furtherance of the purposes of the Full Employment and Balanced Growth Act of 1948.” In contrast, the statutes of the two oldest central banks, the Swedish Riksbank (1668) and the Bank of England (1694) do not specify any developmental goals.
The absence of statutory provision for promotional activity has not inhibited central banks even in developed countries from using monetary policies to implement basic national economic goals. For instance, the Swedish Riksbank has been active in promoting programs for priority sectors, such as housing, principally through asset reserve requirements. Similarly, the Bank of England which, historically, has taken a very broad view of its functions as the “Curator of Financial Organization,” pioneered in establishing specialized institutions like the Industrial and Commercial Finance Corporation, the Finance Corporation for Industry, the Securities Management Trust, and the Bankers’ Industrial Development Company. The central banks of Italy, the Federal Republic of Germany, Japan, and the Netherlands have used various techniques such as asset reserve requirements and lending (with or without interest subsidies) to priority sectors, for example, housing, agriculture, exports, small business, and underdeveloped regions. Such promotional techniques have been justified on the grounds that these are typically the sectors which suffer disproportionately from credit restrictions in deflationary policies.
This article is based on a longer paper presented to the Asian Seminar on Financial Structure and Policies, February 8-20, 1987, Bombay. The complete version is due for publication in The International Journal of Development Banking (published by the Industrial Credit and Investment Corporation of India, Bombay).
The statutes of central banks and monetary authorities established in the 1970s and 1980s, with the technical assistance of the International Monetary Fund, have specific provisions for developmental roles (e.g., Bhutan, Botswana, Fiji, Maldives, Solomon Islands, Swaziland, and Vanuatu). Central banks may, however, take a rather long time to implement developmental objectives even when they have the necessary legal mandate. For instance, the Statutory Report of the Reserve Bank of India, issued in 1938, observed: “During a period of financial development such as exists in India today, it may be desirable for Central Bank credit to be made available in a larger number of ways and with less restrictions than when the financial structure is more complete.…” (p. 35). But it was not until the 1950s that the Reserve Bank of India embarked on its developmental activities.
In addition to their role in promoting the development of the domestic financial sector, central bank operations also have a bearing on foreign borrowing by both the private and the public sector in developing countries, thus contributing to development by helping monitor and raise needed resources. While public foreign debt is guaranteed and approved by the ministry of finance in most developing countries, there are instances where these functions are shared with the central bank. Most private foreign borrowing is handled mainly through the central bank, but again there are some cases where the bank shares the approval authority with the finance ministry.
More than statutes and formal powers, it is the central bank’s status, expertise, and influence which determine the efficacy of its promotional activities as a regulator, innovator, participant, guarantor, and catalyst. The various techniques of central banking like variation of reserve ratios, open market operations, bank rate policy, rediscount and refinance facilities, and selective credit controls can function concurrently as instruments of monetary as well as development policy. Further, there is no one-to-one relationship between monetary instruments and targets since the same instrument can have multiple targets.
Even if a central bank adopts a passive approach to its developmental role, as is the case in many developed economies, the neutrality of monetary policy is not assured. Consequently, even in the absence of formal credit directives credit priorities will be created. The large corporate business sector effectively functions as the preferred sector for credit in all industrialized countries even when it is the primary target of credit restrictions. Central banks in developing countries, which have less developed financial sectors and are also more prone to financial market failures, need to take a more active role in making up for these shortcomings. This can be achieved by the central bank through a coherent strategy of widening and deepening financial intermediation and savings mobilization, involving greater maturity transformation, enlargement of portfolio choices of savers and investors, reduction of transaction and information costs, and the redress of sectoral and regional financial imbalances. These objectives cannot be achieved by the unaided efforts of the private sector. In an underdeveloped economy the development of an adequate banking system must take place before it can serve as an efficient transmission mechanism for monetary policy.