Mounting demand for central bank independence
Thursday, 28 June 2007
Dr.Jamaluddin Ahmed FCA
THERE are two concepts of independence. One focusses on goal independence and the other on instrument independence. The goal independence is found, for example, in the German case in which the Bundesbank does not get any instruction from the government. The Bundesbank sets its own goal and then uses the available instruments in order to meet the goal. With instrument independence, the tragets are set by the government and the central bank is completely free to use the policy instrument at its disposal in order to meet the assigned target. In addition, central bank is free from any obligation to finance the government's budget. The complete separation between the policies of the central bank and the budgetary needs of the government, is put in order to ensure that the intrinsic government's inflation-bias does not result in an actual inflation bias.
In addition to the distinction between goal and instrument independence, the very concept of central bank independence requires further classification. One needs to distingush between legal independence that can be inferred from the language of the law, and actual independence that depends on the actual practice and on the way in which law is being interpreted and implemented. For example, in many developing countries, it is difficult to assess the actual degree of central bank independence from analysing only the language of central bank law, because the text of the law is convincing, but record of implementation is not. In other countries, on the otherhand, the provisions contained in the formal central bank law are not strong but yet, the actual degree of independence is nevertheless impressive. It is argued that the issue of central bank independence is not just a juridical issue but rather, it is a practical one.
Demand for central bank independence: Interest in the topic of central bank independence has grown significantly over the past few years. From 1989 to the present times, over 30 central bank laws were revised, were rewritten, and all in one direction, namely strengthening the independence of the central bank. Several reasons underlie the movement towards strengthening central bank independence.
First, countries that were successful in maintaining low inflation have typically enjoyed better economic performance than countries that were unable to control inflation.
Second, the world has undergone a conceptual revolution. In contrast with previous beliefs, the experience of the 1960s and 1970s has revealed that there is no long term trade-off between inflation and unemployment. Accordingly, one cannot produce permanent jobs and accelerate growth on a sustainable basis by creating inflation. Attempts to exploit this trade-off have failed and have resulted in disappointment, frustration, and costly economic distortions. The conceptual revolution has yielded the conclusion that price stability contributes to good economic performance while inflation is a source of instability and economic cost.
Third, there has been a fundamental change in the views about the role that governments and economic policy can and should play in the market economy. There is now growing scepticism about the effectiveness of central planning. There is also scepticism about the capacity and the ability of governments to be effective participants in the market place. There is a growing conviction that free enterprise led by the private sector is the best framework within which one can generate investment and sustainable growth.
Finally, there is also a growing conviction that in order to promote investment and growth one needs to generate price stability. Thus, the new view about the role of government and the desire to promote sustainable growth within a market economy brought about renewed interest in the conditions necessary for price stability. There have also been four important historical developments that took place in the past few years and that contributed to the growing interest in central bank independence.
First, the creation of the European Union(EU) brought about negotiations on the creation of a new European Central Bank. The Maastricht Treaty specified the key characteristics of the law of the new central bank. Accordingly, the central bank must be independent, and its main objective must be price stability; the Bank must keep distance from the governments and, thereby, it should be kept free from political pressures, etc.. The European countries that have signed this treaty have adjusted their own central bank legislation so as to conform with the provisions of the law of the new European Central Bank. This process heightened the official interest in, and the public's awareness and familiarity with the topic of central bank independence.
The second development that stimulated interest in the subject was the urgent need to create several new central banks due to the collapse of the Soviet Union that brought about the creation of independent republics. These republics have realised the need to have a new central bank that is independent.
The third development arose from the experience of several countries in Latin America that recognised that their suffering from high inflation was associated with having weak, and not sufficiently independent central banks.
The fourth development has been the emergence of globalised capital markets. More and more countries have realised that in order to succeed in the new highly competitive global environment, countries must be held in high regard by the various rating agencies that grade the economies' risk. These ratings depend heavily on the countries' track record of fighting inflation and on the institutional setting that governs the economic policy making process. Therefore, the conclusion that has emerged is that a country that wishes to maintain access to the international capital market must aim at achieving price stability and must exhibit a good inflation track record. In addition, it must also have the appropriate institutional and legal framework that underlie the policy making process. Prominent among such institutions is the presence of a independent central bank. It is argued that there are incentives that produce an intrinsic bias towards a higher rate of inflation than is socially desirable, and that an independent central bank can remove this bias.
The following are the criteria developed under different heading of independence for a central bank:
Political Independence: The central bank independence includes, among others, that its Governor is not appointed by the government, the Governor is appointed for more than five years; Board members are not appointed by the government and Board members are appointed for than five years. There is no mandatory participation of government representative in the Board and no government approval of monetary policy is required. Statutory requirement is that the central bank pursues monetary stability and explicit conflicts with the government is not possible.
Economic independence includes: direct credit facility not automatic, direct credit facility - on the market interest rate and direct credit facility- temporary, direct credit facility- limited amount. The central bank does not participate in the primary market for public debt; discount rate is set by the central bank and there are no portfolio constraints and no credit ceiling.
Financial Independence includes, budgetary independence. The salaries of central bank officials and employes are determined by the bank itself. The allocation of profit is determined by the central bank. The degree of financial independence can be assessed considering these variables.
Assessment of independence: Questions which should be examined in assessing central bank independence include those relating to the length of the tenure of the governor and the dependence of this tenure on the timing of changes in governments. Does the new government have the power to replace the governor prior to the end of his term? Should interest rate decision can be taken by a board and how many persons should be included in such a Board? How many of the board members should be insiders, how many outsiders? Can the members of the board earn salaries from other sources? Who determines the budget of the central bank? What happens when there is disagreement between government and the central bank? Who determines the inflation target? Is the bank endowed with all instruments needed for the conduct of monetary policy or does it need to get government approval at each case? In what way and to whom is the bank accountable? Who appoints auditor of the bank and the remuneration thereof? Who authenticates reliability check of foreign direct investment (FDI) figures? To whom does the central bank report--whether it is to the ministry of finance or to the president or to the parliament?
Bangladesh Bank: The Bangladesh Bank Order of 1972 resembles legacy of former Pakistan Central Bank Order drawn in 1950s. This does not provide any of the practicing independence assessment criteria applicable for an efficient central bank compatible with those requirements for operation of market economy because of open and hidden political interference since the independence of the country. In the recent time, a namesake amendment of the central bank order was made by the previous government, which does not indicate any change. Its nine - member Board includes Governor, Deputy Governor-1, the government of Bangladesh (GoB) officials and three GoB nominated persons. The Co-ordination Council is chaired by the Finance Minister, other members are Commerce Minister, the Governor of the central bank, the Finance Secretary, the Internal Resources Division Secretary and a member of the Planning Commission.
The central bank independence index that has been constructed, basing on eight different criteria by Alesina and Grill (1992) on political, economic, and four criteria by Bade and Parkin Indices of Financial Independence (1992), if compared with the Bangladesh Bank Order, indicates that these do not meet the qualifying criteria for an independent central bank. Under section 9(3) (d) of the Bangladesh Bank Order, the government has the authority to appoint three government officials at the Board which is in addition to four directors from outside which historically proved to be a choice of discretion. The length of service of the governor has been lower than the best practice and those followed in the neighbouring Asian. The current governor joined in his job in Feb 2005. During 1972-2007, the highest length of service of a governor was 11 years (between 1976-87) while the second highest was five years. Four govenors served four years each, one three years and other served the lowest term of two years. Compared to international best practices, only one governor completed more than sie years.
Morover, there was no stability on the tenure of the govrnor, the deputy governor (s) and the director(s) of the Bangladesh Bank. Under articles 10(9), 15(1) (a) and 15(1) (b) of the Bangladesh Bank Order, continuation of the position of the governor, the deputy governor(s) and director(s) depends on the pleasure of the government i.e practically, on the desire of the Finance Ministry and party in power. Moreover, section 10(10) of the said Order authorised the government to grant leave to the governor and the deputy governor(s) for any period of time as desired by the Finance Ministry. This arbitry power was misused on several ocasions, by transfering them to other places. This most striking example was the case of deputy governor Mr Ruhul Amin who was granted forced leave on difference of opinion with the Finance Minister of the last government.
Section 9A of the Bangladesh Bank Order authorises Co-ordination Council to coordinate the macro-economic framework including fiscal, monetary and exchange rate policy and finalize public sector borrowing which works as hindrance to ensure consistency among marcoeconomic targets. Its Article 82(2A) states that salary and compensation package of employees would be subject to approval of the government which also work as an obstacle to reward, punishment, and employee motivation. Section 65 of the Order defines the prodecure of appointing external auditors by the GoB which in other countries are done by the Board and the audit fee of the Bangladesh Bank is negligible Tk 0.03m divided between two firms compared to those of Pakistan at Rs 2.5 m and India at Rs 4.5m. This indicates the current state of corporate governance within the central bank of Bangladesh. For transparency and corporate governance these provisions needs to be deleted from the statute.
Now time has come when a truly non-party caretaker government is running the administration of the country. This government can form a task force to make recommendation to the government for the independence of the Bangladesh Bank under the terms and conditions that are compatiable with the needs to promote and facilitate ongoing economic liberalisation towards market economy. The terms of reference of the proposed committee should at least cover, examination of the central bank charter of from two neghobouring countries, one from the Western Europe, one from the Eastern Europe and one from Latin America and those should be compared with the provision of the Bangladesh Bank Order. The committee should recommend the ways and means to ensure minimum requirement of independence criteria to ensure the terms of appointment of the governor and the deputy governor, restructure the Board freed from any political pressure, redefine the terms of reference of of the Board of Directors, and ensure legal operational, economic and financial independence.
Professional bodies dealing with the economy, business, industry and trade should raise their voice to ensure independence of the Bangladesh Bank in order to facilitate and promote the transition Bangladesh economy from state to market.
The writer is a partner of Hoda Vasi Chowdhury Co, an independent correspondent firm to Deloitte Touche Tohmatsu. He is also the Vice President of the Institute of Chartered Accountents of Bangladesh and the Treasuer of Bangladesh Economic Association. He can be reached at e-mail: [email protected]
THERE are two concepts of independence. One focusses on goal independence and the other on instrument independence. The goal independence is found, for example, in the German case in which the Bundesbank does not get any instruction from the government. The Bundesbank sets its own goal and then uses the available instruments in order to meet the goal. With instrument independence, the tragets are set by the government and the central bank is completely free to use the policy instrument at its disposal in order to meet the assigned target. In addition, central bank is free from any obligation to finance the government's budget. The complete separation between the policies of the central bank and the budgetary needs of the government, is put in order to ensure that the intrinsic government's inflation-bias does not result in an actual inflation bias.
In addition to the distinction between goal and instrument independence, the very concept of central bank independence requires further classification. One needs to distingush between legal independence that can be inferred from the language of the law, and actual independence that depends on the actual practice and on the way in which law is being interpreted and implemented. For example, in many developing countries, it is difficult to assess the actual degree of central bank independence from analysing only the language of central bank law, because the text of the law is convincing, but record of implementation is not. In other countries, on the otherhand, the provisions contained in the formal central bank law are not strong but yet, the actual degree of independence is nevertheless impressive. It is argued that the issue of central bank independence is not just a juridical issue but rather, it is a practical one.
Demand for central bank independence: Interest in the topic of central bank independence has grown significantly over the past few years. From 1989 to the present times, over 30 central bank laws were revised, were rewritten, and all in one direction, namely strengthening the independence of the central bank. Several reasons underlie the movement towards strengthening central bank independence.
First, countries that were successful in maintaining low inflation have typically enjoyed better economic performance than countries that were unable to control inflation.
Second, the world has undergone a conceptual revolution. In contrast with previous beliefs, the experience of the 1960s and 1970s has revealed that there is no long term trade-off between inflation and unemployment. Accordingly, one cannot produce permanent jobs and accelerate growth on a sustainable basis by creating inflation. Attempts to exploit this trade-off have failed and have resulted in disappointment, frustration, and costly economic distortions. The conceptual revolution has yielded the conclusion that price stability contributes to good economic performance while inflation is a source of instability and economic cost.
Third, there has been a fundamental change in the views about the role that governments and economic policy can and should play in the market economy. There is now growing scepticism about the effectiveness of central planning. There is also scepticism about the capacity and the ability of governments to be effective participants in the market place. There is a growing conviction that free enterprise led by the private sector is the best framework within which one can generate investment and sustainable growth.
Finally, there is also a growing conviction that in order to promote investment and growth one needs to generate price stability. Thus, the new view about the role of government and the desire to promote sustainable growth within a market economy brought about renewed interest in the conditions necessary for price stability. There have also been four important historical developments that took place in the past few years and that contributed to the growing interest in central bank independence.
First, the creation of the European Union(EU) brought about negotiations on the creation of a new European Central Bank. The Maastricht Treaty specified the key characteristics of the law of the new central bank. Accordingly, the central bank must be independent, and its main objective must be price stability; the Bank must keep distance from the governments and, thereby, it should be kept free from political pressures, etc.. The European countries that have signed this treaty have adjusted their own central bank legislation so as to conform with the provisions of the law of the new European Central Bank. This process heightened the official interest in, and the public's awareness and familiarity with the topic of central bank independence.
The second development that stimulated interest in the subject was the urgent need to create several new central banks due to the collapse of the Soviet Union that brought about the creation of independent republics. These republics have realised the need to have a new central bank that is independent.
The third development arose from the experience of several countries in Latin America that recognised that their suffering from high inflation was associated with having weak, and not sufficiently independent central banks.
The fourth development has been the emergence of globalised capital markets. More and more countries have realised that in order to succeed in the new highly competitive global environment, countries must be held in high regard by the various rating agencies that grade the economies' risk. These ratings depend heavily on the countries' track record of fighting inflation and on the institutional setting that governs the economic policy making process. Therefore, the conclusion that has emerged is that a country that wishes to maintain access to the international capital market must aim at achieving price stability and must exhibit a good inflation track record. In addition, it must also have the appropriate institutional and legal framework that underlie the policy making process. Prominent among such institutions is the presence of a independent central bank. It is argued that there are incentives that produce an intrinsic bias towards a higher rate of inflation than is socially desirable, and that an independent central bank can remove this bias.
The following are the criteria developed under different heading of independence for a central bank:
Political Independence: The central bank independence includes, among others, that its Governor is not appointed by the government, the Governor is appointed for more than five years; Board members are not appointed by the government and Board members are appointed for than five years. There is no mandatory participation of government representative in the Board and no government approval of monetary policy is required. Statutory requirement is that the central bank pursues monetary stability and explicit conflicts with the government is not possible.
Economic independence includes: direct credit facility not automatic, direct credit facility - on the market interest rate and direct credit facility- temporary, direct credit facility- limited amount. The central bank does not participate in the primary market for public debt; discount rate is set by the central bank and there are no portfolio constraints and no credit ceiling.
Financial Independence includes, budgetary independence. The salaries of central bank officials and employes are determined by the bank itself. The allocation of profit is determined by the central bank. The degree of financial independence can be assessed considering these variables.
Assessment of independence: Questions which should be examined in assessing central bank independence include those relating to the length of the tenure of the governor and the dependence of this tenure on the timing of changes in governments. Does the new government have the power to replace the governor prior to the end of his term? Should interest rate decision can be taken by a board and how many persons should be included in such a Board? How many of the board members should be insiders, how many outsiders? Can the members of the board earn salaries from other sources? Who determines the budget of the central bank? What happens when there is disagreement between government and the central bank? Who determines the inflation target? Is the bank endowed with all instruments needed for the conduct of monetary policy or does it need to get government approval at each case? In what way and to whom is the bank accountable? Who appoints auditor of the bank and the remuneration thereof? Who authenticates reliability check of foreign direct investment (FDI) figures? To whom does the central bank report--whether it is to the ministry of finance or to the president or to the parliament?
Bangladesh Bank: The Bangladesh Bank Order of 1972 resembles legacy of former Pakistan Central Bank Order drawn in 1950s. This does not provide any of the practicing independence assessment criteria applicable for an efficient central bank compatible with those requirements for operation of market economy because of open and hidden political interference since the independence of the country. In the recent time, a namesake amendment of the central bank order was made by the previous government, which does not indicate any change. Its nine - member Board includes Governor, Deputy Governor-1, the government of Bangladesh (GoB) officials and three GoB nominated persons. The Co-ordination Council is chaired by the Finance Minister, other members are Commerce Minister, the Governor of the central bank, the Finance Secretary, the Internal Resources Division Secretary and a member of the Planning Commission.
The central bank independence index that has been constructed, basing on eight different criteria by Alesina and Grill (1992) on political, economic, and four criteria by Bade and Parkin Indices of Financial Independence (1992), if compared with the Bangladesh Bank Order, indicates that these do not meet the qualifying criteria for an independent central bank. Under section 9(3) (d) of the Bangladesh Bank Order, the government has the authority to appoint three government officials at the Board which is in addition to four directors from outside which historically proved to be a choice of discretion. The length of service of the governor has been lower than the best practice and those followed in the neighbouring Asian. The current governor joined in his job in Feb 2005. During 1972-2007, the highest length of service of a governor was 11 years (between 1976-87) while the second highest was five years. Four govenors served four years each, one three years and other served the lowest term of two years. Compared to international best practices, only one governor completed more than sie years.
Morover, there was no stability on the tenure of the govrnor, the deputy governor (s) and the director(s) of the Bangladesh Bank. Under articles 10(9), 15(1) (a) and 15(1) (b) of the Bangladesh Bank Order, continuation of the position of the governor, the deputy governor(s) and director(s) depends on the pleasure of the government i.e practically, on the desire of the Finance Ministry and party in power. Moreover, section 10(10) of the said Order authorised the government to grant leave to the governor and the deputy governor(s) for any period of time as desired by the Finance Ministry. This arbitry power was misused on several ocasions, by transfering them to other places. This most striking example was the case of deputy governor Mr Ruhul Amin who was granted forced leave on difference of opinion with the Finance Minister of the last government.
Section 9A of the Bangladesh Bank Order authorises Co-ordination Council to coordinate the macro-economic framework including fiscal, monetary and exchange rate policy and finalize public sector borrowing which works as hindrance to ensure consistency among marcoeconomic targets. Its Article 82(2A) states that salary and compensation package of employees would be subject to approval of the government which also work as an obstacle to reward, punishment, and employee motivation. Section 65 of the Order defines the prodecure of appointing external auditors by the GoB which in other countries are done by the Board and the audit fee of the Bangladesh Bank is negligible Tk 0.03m divided between two firms compared to those of Pakistan at Rs 2.5 m and India at Rs 4.5m. This indicates the current state of corporate governance within the central bank of Bangladesh. For transparency and corporate governance these provisions needs to be deleted from the statute.
Now time has come when a truly non-party caretaker government is running the administration of the country. This government can form a task force to make recommendation to the government for the independence of the Bangladesh Bank under the terms and conditions that are compatiable with the needs to promote and facilitate ongoing economic liberalisation towards market economy. The terms of reference of the proposed committee should at least cover, examination of the central bank charter of from two neghobouring countries, one from the Western Europe, one from the Eastern Europe and one from Latin America and those should be compared with the provision of the Bangladesh Bank Order. The committee should recommend the ways and means to ensure minimum requirement of independence criteria to ensure the terms of appointment of the governor and the deputy governor, restructure the Board freed from any political pressure, redefine the terms of reference of of the Board of Directors, and ensure legal operational, economic and financial independence.
Professional bodies dealing with the economy, business, industry and trade should raise their voice to ensure independence of the Bangladesh Bank in order to facilitate and promote the transition Bangladesh economy from state to market.
The writer is a partner of Hoda Vasi Chowdhury Co, an independent correspondent firm to Deloitte Touche Tohmatsu. He is also the Vice President of the Institute of Chartered Accountents of Bangladesh and the Treasuer of Bangladesh Economic Association. He can be reached at e-mail: [email protected]