Understanding central bank autonomy

Understanding central bank autonomy
10 Sep, 2007, 0442 hrs IST,Mythili Bhusnurmath, TNN

NEW DELHI: Research has already established that there are significant benefits for macroeconomic performance from central bank autonomy (CBA). CBA helps countries achieve lower average inflation, cushions the impact of political cycles on economic cycles, enhances financial system stability, and boosts fiscal discipline without any real additional costs or sacrifices in terms of output volatility or reduced economic growth.

Now an IMF paper that looks at trends over time in CBA of 163 central banks representing 181 countries (India is not included in the sample) delves deeper into the issue, more specifically into two aspects of such autonomy: political and economic autonomy.

Political autonomy is defined as the ability of central banks to select the final objectives of monetary policy, based on eight criteria: (1) governor is appointed without government involvement; (2) governor is appointed for more than five years; (3) board of directors is appointed without government involvement; (4) board is appointed for more than five years; (5) there is no mandatory participation of government representative(s) in the board; (6) no government approval is required for formulation of monetary policy; (7) central bank is legally obliged to pursue monetary stability as one of its primary objectives; and (8) there are legal provisions that strengthen the central bank’s position in the event of a conflict with the government.

Economic autonomy assesses the central bank’s operational autonomy on the basis of seven criteria: (1) there is no automatic procedure for the government to obtain direct credit from the central bank; (2) when available, direct credit facilities are extended to the government at market interest rates; (3) this credit is temporary; (4) and for a limited amount; (5) the central bank does not participate in the primary market for public debt; (6) the central bank is responsible for setting the policy rate; and (7) the central bank has no responsibility for overseeing the banking sector or shares responsibility.

Assessing the performance of the sample group of central banks against these two yardsticks, the paper concludes: Average CBA scores have increased significantly over the last couple of decades: overall CBA (political and economic autonomy) has about doubled, but the economic element of autonomy is significantly ahead of the political component.

Advanced economies started off from relatively high levels of autonomy in the late 1980s but continued to strengthen their CBA in the subsequent years. Since their economic autonomy was already quite high, most progress has been towards boosting the political autonomy. However, the political component of autonomy still lags behind the scores for economic autonomy.

Among emerging markets, overall CBA has more than doubled over time and has surpassed CBA, typical in the advanced countries in the late 1980s. Measures of economic and political autonomy show similar levels of improvement, with economic autonomy remaining higher than political autonomy.

In developing countries, political autonomy of central banks has improved only marginally and remains low. The good thing, however, is that economic CBA has increased significantly over the past couple of decades.

According to the authors, political autonomy is much harder to win than economic autonomy. In developing countries, governments often continue to be involved in the selection of central bank boards and tenures tend to be short; the government is generally represented on the board and central banks have a limited legal protection in the event of a conflict with the government.

The four main principles of any legal framework for CBA include:

Setting price stability as the primary objective of monetary policy
Governments may have several competing economic objectives, particularly in the short term. Accordingly, they may tend to ignore the medium-term inflationary effects of an expansionary monetary policy. This time-inconsistency causes a credibility problem. Entrusting price stability to an autonomous agency ( i.e., the central bank) helps strengthen credibility.

Curtailing direct lending to governments

Most central banks have provisions in place that limit their ability to provide unrestricted credit to the government. Today, almost all central bank laws stipulate that lending to the government, if allowed at all, cannot be automatic, and must be temporary, subject to quantitative limits and at market-related interest rates.

Ensuring full autonomy for setting the policy rate

Most central banks have been granted full autonomy for setting their policy rate. At the most basic level, this condition is necessary for the central bank to pursue its goals. A corollary to that consensus view is the desire to ensure that the central bank has full autonomy for the design of its monetary policy instruments, i.e., the tools to achieve the operational target of monetary policy.


Ensuring no government involvement in policy formulation

No government approval should be required for the formulation of monetary policy. A corollary to that principle is the existence of procedures to resolve conflicts between the central bank and the government.

With the exception of the second — curtailing direct lending to government — we do not make the grade on any of the remaining counts. No wonder that differences between the government and the RBI will increasingly see the central bank on its back foot, with unhappy long-term consequences for the economy?