A K N AHMED

A

central bank of an orthodox and classical type concerns itself with the cost and availability of credit to the economy but when it is transposed to developing countries, it takes an altogether different shape because of the perception that there is a pervasive market failure in developing countries, which necessitates frequent government intervention. This led the emerging central banks to assume a developmental role, in addition to their monetary policy functions, which required them to set up financial institutions for catering to the credit needs of infant industry and agriculture. Naturally, central banks then tended to become a part of the government, if not one of its departments. This intimacy is reflected in the nature of the instruments that the central bank employs to discharge its functions. If the cost of credit to needy sectors is high, the central bank has to scale it down; if the quantum of credit is short, it has to expand irrespective of whether monetary conditions warrant it or not. These changes are unidirectional. Even more important than this is the imperative to help the government to meet its need for resources to finance interventionist activities. Thus, one of its main instruments of monetary control, i e, discount rate policy, is often blunted. Other instruments such as open market operations, cash reserve ratio, and liquid assets ratio are merely fiscal instruments with a monetary intent. If the government needs finance, the central bank in developing countries often raises the cash ratio far above the level required as a safety valve (i e, an inflation tax); the liquid assets ratio is raised so that banks divert credit to the government from the private sector; and open market operations become a proxy for public debt management. In consequence, the distinction between fiscal and monetary policy is almost erased [Khatkhate 2005].

In such a milieu, there should not be any question about the autonomy of a central bank. The monetary and financial landscape of developing countries, however, changed radically after economic reform policies are ushered in and interest controls are, first, diluted and finally removed. Markets are allowed to determine their level and central banks guide their course through changes in the discount rate or other instruments. The extent of direct monetisation of public debt is made less automatic and in some cases totally abandoned; the foreign sector of the economies is liberalised, particularly its current account which permits inflow of foreign resources and the exchange rate policy becomes more flexible. Once this spectre of the free flow of credit to the government is buried, the central bank comes to deal with its principal domain of regulating the cost and availability of credit in such a way that non-inflationary growth of the economy is ensured. This requires that the central bank maintains an arm’s length relationship with the government. The rationale of central bank independence has received added impetus from the recent shift to inflation targeting. The government by its very nature is powerless to set such a target because inflation control entails restrictions on the flow of credit and rise in its cost, which in developing countries, in particular is, opposed by the vote-banks of the party in power or out of power.

There is an allied issue of the federal structure of the central bank in economies with political, constitutional and fiscal federalism. It is found, though the evidence is not decisive, that there is “a positive cross country relation between federalism and the central bank independence” [Chandavarkar 2005]. There is also a presumption in such economies that a monetary policy impacts differentially on the constituent parts of the federation.

I propose to reflect on these issues of central bank independence and its federal structure from the perspective of a central banker, being a former senior official of the State Bank of Pakistan and later governor of the Bangladesh Bank. In this task I am stimulated by an erudite and comprehensive discussion of problems of autonomy and monetary federalism by Anand Chandavarkar in the Indian context [Chandavarkar 2005]. I will speculate on how these two objectives could be achieved and through which instrumentalities.

The most telling case for central bank autonomy was made, surprisingly, by the finance member of the government of colonial India when he introduced a bill for setting up the Reserve Bank of India. His logic was based on the distinction between the power to create money and the power to spend money. He argued that:

…in modern life and in modern economic organisation, there are two important

The H T Parekh Finance Forum is edited and managed by Errol D’Souza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty.

Economic and Political Weekly September 9, 2006

functions: they are the functions of those who have to raise and use money and there are the functions of those who are responsible for producing the actual tokens of money, the money in circulation. The basis of the whole proposal for setting up an independent central bank is to keep these functions separate [RBI 1970]. The Nobel Laureate economist J R Hicks made out a case for the central bank independence on political and constitutional grounds. “I should say that monetary regulation is a major function of government but we should emphasise that if it needs to be exercised decisively, it needs to be separated, in what is in fact the constitutional sense, from other functions” [Hicks 1977]. He goes on to compare it with the judicial function.

Routes to Central Bank Independence

Thus the independence of the central bank in a market-oriented economy is no longer a disputable issue in theory but problems arise in regard to the ways to achieve it. I for one would opt for a course of action that is not flawless but practical. First, de facto independence can be maintained by an informal but well-defined arrangement between the government and the central bank. A finance minister and the governor of the central bank, with their officers, can meet with a fixed timetable to discuss issues relating to monetary conditions in the overall context of the economy. Though informal, they can lay a solid foundation for reaching a consensus between the two parts of government. However, the experience of many countries – developed and developing – has shown that this rarely works, if at all. The government has one ear open to its principal, i e, the voters, and it puts a premium on what concerns them. The result is, very often, that the central bank comes out a cropper.

The second way is to institute a de jure channel for discourse between the government and central bank. This can be done by a legislation, which enshrines the operational independence of the central bank. However, the difficulty with this option is that every time the government changes, with the opposition replacing the ruling party, a new legislation can be passed to supercede the earlier one. An alternative is to have a constitutional provision as suggested by Chandavarkar to guarantee the autonomy of the central bank, which is difficult to remove. However, if one goes by the experience of India, the largest federal democracy, such an expectation is belied as it has amended its Constitution over 200 times. The constitutional provision does not mean that it is written in stone.

What I would suggest as a practitioner is to devise a convention through formal agreement between the government and the central bank. Under this convention, the government will define the qualifications of a governor and propose his/her name to Parliament in the same way that the US president does with regard to the nomination of the Federal Reserve Board chairman. The nominee can be questioned about how he will conduct monetary policy, his views on the important monetary matters, and in the end the parliament will confirm the nominee (or not). The same procedure will apply to the tenure of the governor. It should be for a fixed term and he/she should not be removed before tenure ends without the vote of Parliament.

Furthermore, the central bank governor should be asked to present, every six months, the contours of a policy he proposes for the coming six months, the evidence on which his policy is based and his medium-term forecast, derived from the internal research at the central bank, about how the economy will move. This policy statement will be debated. Feedback from the executive and legislature will enable the central bank to modify the statement, if need be. Thus the independence of the central bank can be maintained and yet its function will be detached from the overall economic policy of the government. This again is a convention patterned on US practice, which smoothens the relationship between the government, Senate and Federal Reserve.

Federalism in US and Pakistan

The question of a federal central bank can be discussed in the context of separation of monetary policy. Before coming to this aspect, I will recall first how the Federal Reserve System in the US has evolved so that it can provide some clues to converting a unitary central bank in a country like India into a federal central bank. I will also briefly allude to the experiment Pakistan carried out in order to federalise the State Bank of Pakistan before the birth of Bangladesh.

The Federal Reserve System consisting of 12 federal reserve banks is a product of the historical evolution of US banking. When the US constitution was framed, the 13 existing sovereign states then ceded certain powers to the federal government, retaining all residual powers with themselves. Banking was one of them. This is why, until recently, banks registered in one state could not function in other states and each state regulated banks incorporated within its jurisdiction without outside interference. When the Federal Reserve System came into existence, in the wake of a banking crisis to control money supply and banks, regional loyalties and the sense of sovereignty of individual states had to be partially accommodated by creating 12 regional federal banks. In theory they are equal in status but right from the start one was more equal than others, as in the allegory of George Orwell’s Animal Farm. The more equal one is the Federal Reserve Bank of New York, which has been wielding from its inception extraordinary powers and added clout because of the immense importance of New York as a financial centre, and also because it holds the gold reserves of the US and acts as the agent of the Federal Reserve System for all global financial transactions. Over the years as the US economy expanded and the federal government tended to become more centralised, the erosion of regionalism and states’ powers gradually ensued. There now emerged a common market for banking with elimination of restrictions on branch banking. Though there is a federal structure in the system, it is now more centralised, the only difference being that on the open market committee, deliberating and deciding monetary policy stance and operating procedures, regional federal banks are represented on a rotation basis.

In Pakistan, before its division into two nations, there was a serious effort made to restructure the State Bank of Pakistan into a federal central bank. Being one of the main actors in the drama, I remember how we were struggling to decentralise the central bank so that East Pakistan, as it was known then, would have more voice in the supervision and regulation of banks, so there was fair distribution of foreign exchange earned by East Pakistan and foreign aid, and monetary policy

Economic and Political Weekly September 9, 2006 was steered in such a manner that more bank credit was available and more bank branches were opened, particularly in rural areas. All that was achieved, however, was a caricature of a federal central bank with separate computation of money supply and credit expansion limits for East Pakistan, somewhat wider powers for release of foreign exchange to individuals, a localised office of a deputy governor and other minutiae. It became clear by the late 1960s that the decentralisation of institutions and their functions were a pipe dream when political dynamics were against it.

Federal Central Bank in India?

India perhaps qualified for contemplating a federal central bank by virtue of its formidable democratic foundation, evolution of a strong national identity, and the experience of the dominance of one political party both at the centre and in the states, which could ensure a political consensus for a long time after independence. There seems to be also a prima facie case on economic grounds for instituting a federal central bank as research shows that the monetary policy of the Reserve Bank has a differential impact on the states, distinguished by the level of their economic development [Nachane et al 2002]. However, these factors by themselves are by no means decisive. One party dominance at the centre and in the states in India is a thing of the past and now a coalition of disparate regional political parties, dominated by a sectarian vision, is the new mantra. It is now clear the regional parties do not take a national view and plumb for the agenda that goes well with their respective vote banks. For this reason, a federal central bank, far from being an effective instrument of voice for the regions, would be a Tower of Babel.

Even assuming that the Reserve Bank’s monetary policy has a differential impact on states, is it practical and feasible that the monetary authority can devise a policy which differentiates between states? It requires a leap of faith to believe that a differential interest policy, aimed at lower rates in low activity states and higher rates in others will succeed. In such an eventuality, borrowers from high interest rate states would switch to lenders in low interest states and in a common market for money and finance such an outcome cannot be prevented.

It is however possible to have an epigone of a federal central bank in India, if the existing regional boards of directors can be suitably reorganised to give them teeth, unlike at present, when they are just dysfunctional bodies with ears tuned to what the governor orates from time to time. These bodies can be made more functional through minor administrative action. The regional board can be provided with research services, which can enable them to prepare an agenda for discussion at the meetings, based on the research of monetary and credit conditions and enterprises in their respective jurisdictions. The discussion at the meeting can thus be wellinformed and candid and help the governor to take their concerns in the preparation of his six-monthly statement to be presented before the Parliament as suggested earlier in this article. Thus regional and national interests could be made mutually reinforcing.

I call what I have stated here ruminations and the ideas are not fully worked out. There are many other facets of the problems, legal and political, which go beyond my competence. Maybe I am an exemplar of J K Galbraith’s aphorism, “Economists are economical, among other things, of ideas. Most make those of their graduate days last a life time”.

EPW

[I thank my friend, Deena Khatkhate for his comments and suggestions on the earlier draft of this paper. Sole responsibility for the views expressed herein rests with me.]

References

Chandavarkar, Anand (2005): ‘Towards an Independent Federal Reserve Bank of India: A Political Economy Agenda for Reconstitution’, Economic and Political Weekly, August 27.

Hicks, J R (1977): Economic Perspectives, Oxford University Press, New York.

Khatkhate, Deena (2005): ‘Reserve Bank of India: A Study in the Separation and Attrition of Powers’ in Kapur, Devesh and Mehta (eds),

Public Institutions in India: Performance and Design, Oxford University Press, New Delhi.

Nachane, D, P Ray and S Ghosh (2002): ‘Does Monetary Policy Have Differential State-level Effects? An Empirical Evaluation’, Economic and Political Weekly, November 23.

RBI (1970): History of the Reserve Bank of India, 1953-1970, Bombay.

Samavesh Society for Development and Governance

Bhopal, Madhya Pradesh

We require 2 Associate Coordinators for our Elementary Education Program at Bhopal Samavesh works for integrated development and governance in rural areas of

M.P. Our program for ‘Strengthening Elementary Education in two districts’ is being implemented intensively in 50 primary schools. The program has three focus areas: a) Improving school and classroom environment; b) Enhancing participation of local community and PTAs in schools; c) Strengthening school management systems,

i.e. BRCs and CRCs at the block level. This program is implemented in close contact with our developmental programs in panchayat strengthening and women’s empowerment.

Responsibilities: coordination of field programs, including training of Bal-mitras and government teachers, support to field visits and class-room observations; reporting and documentation. Interaction with BRC, CRC and DIETs; development of training materials and designing training program for teachers. Promotion of children’s activities and community involvement.

Qualifications: master’s degree in education/child development/science/social science. Previous experience of 3 to 5 years in an educational project. Skills in writing and documentation in English and Hindi. Abilities in research studies will be an asset.

Applicants are requested to send their CVs to the Director by courier, speed-post or by e-mail to: samavesh@rediffmail.com or to anwarjafriin@yahoo.com

Director, Samavesh, E-1/138 Arera Colony, Bhopal-462016.

Economic and Political Weekly September 9, 2006