47 political economy of central bank independence_jamal

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Political Economy of Central Bank IndependenceWhat Shapes and What Shakes it?[Author: Dr Jamaluddin Ahmed FCA is the Treasurer of Bangladesh Economic Association, Vice-President of theInstitute of Chartered Accountants of Bangladesh (ICAB), Partner of Hoda Vasi Chowdhury & Co, Chartered

Accountants-an Affiliate Firm to Deloitte Touch Tohmatsu]

Many governments wisely try to depoliticalise monetary policy by, for example, putting it in the hands ofunelected technocrats with long terms of office and insulation from hurly-burly of politics-Blinder (1998), pp.56-57.

IntroductionInterest in the topic of Central Bank Independence has grown significantly over the recentyears. Key analyses of the relating to Central Bank Independence are ample. See for example,Cukierman (1992, 1996), Fischer (1995a, 1995b), Goodhart (1994) and Volcker (1990, 1993).Excepting the capitalist countries, the basic feature of Central banking under commandeconomy was the high concentration of decision mking power in the economy and the central

role in it was on the politicians (Communist Party). When private property ws abolished by thedecree of nationalisation, entire financial system became state owned by merging most of thefinancial institutions. The change to this system after September 1944 can be traced to thewritings of Lenin, the founder of the Soviet State. Lenin saw it thus:

....to proceed with bank natinalisation and to come closer in transforming them into strategic points of socialistpublic book keeping, first of all we have to achieve a real success in increasing the number of the National Bankbranches, in attracting deposits, in facilitating the citizens in their paying in and withdrwals from the bank, inliquidating the queues (in front of branches), in catching and shooting speculators and the ones taking bribes.

Adopted: In Selected works of Lenin (1987) Sofia, Partizdat Vol-7, p. 175

The communist parties justified the creation of state monopoly on the ground that propertygives rights to one or small groups of people of individuals, inimical to the interets of society asa whole. Control of the economy required the concentration of all property in the hand of thecentral government. Accordingly, one tier socialist banking system was created where the centralbank its traditiotional activities with those of commercial banks and for that reason this wastermed as MonoBank. This concentration of control in one institution meant that informationon money flows was readily available and thus readily subject to control whenever required.

Since the collapse of command economy and from 1989 to the present, almost 30 central banklaws were revised, were rewritten, and all in direction, namely strengthening the independenceof the Central Bank. It is true about industrial countries, such as the UK, USA, France, Belgiumand Italy. True about Latin American countries such as Argentine, Chile, Mexico, and Venezuela. It is true about the Republics that belonged to the former socilist countries.According to modern theory of central banking the monetary institutions can be described bythe political and economic independence of central bank. The political independence is definedas the ability of the central bank to choose monetary policy goals autonomously and withoutinterference from the government. The basic determinats for this ability are found in personalindependence (i.e., procedures for appointing and dismissing central bankers, term of office), inthe governments right to give instructions to the central bank as well as the right to veteo, to


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suspend or to defer central banks decision, and its right to be present on the central bankboard. Furthermore, the degree of political independence depends on the formal responsibilitiesof the central bank. The economic independence is defined as the ability of the central bank todetermine the use and the choice of its monetary policy instruments automonously and withoutinterference from the government. Economic independence may be adversly affected by the

central banks obligation to finance the government budget, to supervise commercial banks andby lack of freedom to set interest rates. In addition, the question of who in charge of exchangerate policy, is to be addressed wheather it is the government or the central bank.

Objective of this paper is to carry out (i) a literature review on the theoretical basis of CentralBank Independence (CBI), (ii) conduct a comparative study on the legislative issues relating tothe structure and functions of some selected Central Banks and compare to those ofBangladesh, (iii) review available indexes of measuring the CBI and fit those with that ofBangladesh, (iv) summarise the findings and (v) suggest recommendation for Bangladesh.

Traditional views on central bank Independence The traditional justification of the central bank independence necessity is funded on the

argument that this independence constituted a mean through which the central bank ensures thestability of prices. Why would central bank idependence yield lower rates of inflation? Threearguments are discussed in the literature:

1 Those based on bublic choice arguments: according to this view, the monetary authoritiesare exposed to strong political pressures to behave in accordance with the governmentspreferences. When the economy slows down, the government may prefer a more relaxedmonetary policy, to re-launch the economy.

2 Those based on the analysis of Sergent and Wallace (1981): they distinguish between fiscalauthorities and monetary authorities. This argument relates tot he financial independenceand states that if central bank is dominant than it can oppose to finance the budgetary deficitby creating money, Or, if the fiscal policy is dominant, then the money supply becomesendogenous and the monetary authoritis cannot influence the size of the governmentsbudget deficit. Indeed, as John Maynard Keynes earlier (1923) emphasisesd A governmentcan live for long time by printing money...... it is the form of taxation which the public finds hardes to evadeand even the weakest government can enforce, when it can enforce nothing else.

3 Those based on the time inconsistency problem: Kydland and Prescot (1977); Calvo (1978);Barro and Gordon (1983), argue that the dynamic inconsistency arises when the optimaldecision made in th epresent period for future one,, is no longer optimal when that periodactually starts.

Milton Firemans contribution to central bank issue (1977) was to rlate it to the variability ofinflation. In his nalaysis, Friedman expalined why there could exist a positiove correlationbetween the level of inflation and the vaiability of inflation, across countries and over timeforany country. He argues that government may pursue policy goals, like the level of output andemployment, that can lead to high inflation ; only an independent central bank , can oppose toissueeasy money.


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It is interesting to note here that the mentioned mission given to central bank constitution asimple statement unless accompanies by an operational disposition rgarding the means that canbe used to achieve this mission an by an object criteria to define the concept of price stability.Consequently, the respective mandate entrusted to the central bank, improper if directly usedand interpretable, may be considered as rule (i.e., statement fixing the reference framework in

which the decision are adopted and in which the bank function), if pursuing political regimebased on representative democracy and historical evalution of the central bank and theexclusiveness of its control over financial and monetary system. The importance of such a ruledoes not consist in its operational character but in the fact that it forces tha bank to coceive astrategy whose anticipation by the economic actors can be a source of ecomonic stabilleaving acertain flexibility of action. The independence of the central bank is justified by the fact that itallows the increase of crediability of the anti-inflationary policy conceived by the monetaryauthority. A possibility to solve partially the cridiability problem is the independence of thecentral bank , i.e.the separation of the monetary policy decision of the pressures of otherpolitical authorities.

Gradual support for indepependent central bank gains once the country positions itself towards

market economy shifting from the high degree of centralisation. Financial system undercentralised economy was a monolithic instrument for managing socialist economy which differsfundamentally from that of market economy. Financial processes are considered subordinate tophysical flow under command economy by contrast the financial process dominates physicalflows under the market economy. The financial system play minor role under the commandeconomic system and monatary system is not an allocator of resources but in the marketeconomy finance is prominent in decision making. Under command economy, the financialinstitutions are considered as of secondary importanc in comparison with administrativeinstitutions that directly manage the physical flows. The monetary demand under centralplanning influenced directly neither the volume nor the structure of production and, therefore,the role of money was considerably limited including the sphere of the use of instruments,

markets and financial institutions. By contrast, under the market economy, the monetary andfinancial system is the key deciding factor for physical flows. The independent central bank isconsidered to play role to develop efficient financial system.

Developing countries have enforced institutional reforms concerning the relationship betweengovernment and central bank. Countries in the Hempshere, for example, Argentina, Chile,Colombia, Mexico, and Venezuela, have been atempting to secure their stabilisation progressbyproviding their central banks with more legal independence (Siklos 1995; Cukierman 1996).Apartfrom creating independent central banks by law some countries enforced additional specificmechanisms to make central banks explicitly accountable.If the inflation targets are set by thegovernment for a defined period, or agreed between the government and the central bank,

inflation targeting forms an alternative institutional design for an independent central bankwhich stresses the accountability of the central bank. In this sense, inflation targeting is aimed atpreventing a democratic deficit which can emerge when political decisions are taken by anauthority which is not directly legitimated by elections (Briault, Haldane, and King, 1997; Nolanand Schaling 1996). Three main reasons have been put forward by Debell and Fischer (1994,p.195) for the eststablishment of independent central bank:

First:central bank independence is justified theoreticaly by the existance of incentive constraintsfor politicians that force dependent central banks to realise suboptimally high rates of inflation


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(Persson and Tabellini 1997). Since the study by Kydland and Prescott (1977) this inflation biashas ben discussed primarilyagainst the background of the credibility problems of monetarypolicy caused by the dynamic inconsistency. In addition , the political independence of thecentral bank is aimed at protecting against partisan or electoral cycles in monetary policy (Alesina1988, p.40; Alesina and Roubini 1997, p. 212), which in combination with ex ante uncertain

election outcomes in turn may lead to suboptimally high output volatility and contribute to ahigher inflation bias (Alesina and Gitti 1995).

Second:numerious empirical studies (Eijffinger and Fe Haan 1996 for a survey) claim that inindustrial countries legal measures of central bank independence are inversely related to theaverage inflation. In contrast, there is no systematic relationsship between central bankindependence and economic growth. In the case of developing country it is observed that legalindependence of central banks is not a good measure of actual central central bankindependence. The negative correlation between central bank independence and inflation isconfirmed, however, if so called behaourially oriented indices like actual turnover rates of centralbank governors or the political vulneribility of the central bank governor are used to measure thedegree of central bank independence (Cukierman 1994, 1996).

Third:moreover the track record of the German Bundesbank which is regarded as particualrlyindependent central bank is referred to.

Reasons for move towards strenthening of central bank independence can be identied. First:countries that were successful in maintaining low inflation have typically enjoyed bettereconomic performance than countries that were unable to contol inflation. Second: the worldhas undergone a conceptual revolution in contrast with previous belief that there is no long termtrade-off between inflation and unemployment and this conceptual revolution has yielded theconclusion that price stability controbute to good economic performamce while inflation is asource 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 marketeconomy in place of command economy with a growing conviction that free enterprise led byprivate sector is the best framework whithin which one can generate. Finally: there is also agrowing conviction that in order to promote investment and growth one needs to general pricestability and the new view about the role of government and the desire to promote sustainablegrowth within a market economy, brought about renewed interest in the conditions necessaryfor price stability.

Four important historical developments took place in the past few years and that contributed tothe growing interest in central bank independence. First:the creation of European Central bankspecifying that it must be independent and its main objective must be price stability, keepdistance from the governments and, thereby, it should be kept free from political pressures, etc.This process heightened the official interest in, and the publics awareness and familiarity withthe topic of central bank independence. Second: development that stimulated interest in thesubject was the urgent need to create several new central banks due to the collapse of the SovietUnion that brought about the creation of Independent Republics. These new republics haverealized the need to have new central bank that is independent. Third: experience of sufferingsfrom high inflation in several Latin American countries was associated with having weak and notsiffiently independent central banks. The fourth development has been the emergence ofglobalised capital markets and before entering into the competitive capital narket country credit


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rating is an important element. These ratings depend heavily on the countries track record offighting inflation and on the institutional setting that governs the economic policy making.Added to these, prominent among such institutions is the presence of indpendent central bank.

There are two conncepts of independence. One focusses on goal indpendence and the other on

instrument independence. The goal independence is found for example in the German case inwhich the Bundesbank does not get any instruction from the government. The Bundesbank setsits own goal and then uses the available instruments in order to meet the goal. With instrumentindependence, the tragets are set by the government and the central bank is completely free touse the policy instrument at its disposal in order to meet the assigned target. In addition, centralbank is free from any obligation to finance the governments budget. The complete separationbetween the policies of the central bank and the budgetary needs of the government, is put inorder to ensure that the intrinsic governments inflation bias does not result in an actual inflationbias. In addition to the distinction between goal and instrument indpenednece, the very conceptof central bank independence requires further classification. One needs to distingush betweenlegal indendence that can be inferred from the language of of the law, and actual indendence thatdepends 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 degreof central bank indpendence from analysing only the language of central bank law, because thetext of the law is convincing, but record of implementation is not. In other countris, on theotherhand, the provisions contained in the formal central bank law are not strong but yet, theactual degree of indpendence is nevertheless impressive. In summary, the issue of central bankindependence is not just a juridical issue but rather, it is a practical one.

The empirical and theoretical justification for central bank independenare not undisputed in theliterature. In some cases, the consistency of indices based on interpretation of central bankstatues is disputed in general and in particular concerning some concrete indices (Mangano 1997;Eijffinger and Schaling 1995). In addition the originally maintained correlation between central

bank independence and macroeconomic variables are not always confirmed (Campillo andMiron,1996; Fuhrer 1997), the causality between central bank independence and inflation isdisputed (Posen,1993), and higher disinflation costs as result of a higher sacrifice ratio withcentral bank independence are also calimed (Debelle and Fischer 1994; Fischer 1996; Jordan1997; Hutchison and Walsh 1997). Furthemore the theoretical foundation of central bankindependence, as paer as they are based on the problem of time inconsistency , have not yet fullyreasearched. In this context there is increasing criticism that institutinal reforms do not reallysolve the crediability of th problem, but merely relocate it (McCallum, 1995; Al-Nowaihi andLevine 1996; Jensen 1997; Illing 1998).

Studies were carried out to examine the issue of independence defined variuos indices of

independence including provisions of law, as well as the actual practices. Examination of datarevels strong evidence that in general countries with an independent Central bank have enjoyedbetter economic performance and in particular have had a much better inflation record thancountries with lesser degree of independence.

Questions that were examined in this context inquired about the length of the term of thegovernor; about the dependence of this term on the timing of changes in governments; does thenew government have the power to replace the governor prior to the end of his term; shouldinterest rate decision can be taken by a Board and how many persons should be included in such


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Board? How many of the Board members should be insiders, how manuy outsiders? Can themembers of the Board earn salaries from other sources? Who determines the budget of thecentral bank? What happens when there is disagreement between government and the centralbank? Who determines the inflation target? Is the bank endowed with all instruments neededfor 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?

One of the important asset of a central bank is its crediability that is an essential element formaking a central bank an independent one. There is famous dictum according to whichcrediability is never owned, it is only rentedand a central bank must continually invest in crediabilityand, thereby, establish a track record. Through the track record central bank can accumulatecrediability which is viewed as an asset and is a form of capital and every mistake may be verycostly because it may result in a rapid depreciation. This asset is also reffferred to as reputationthat is considered a precondition for adoption of long term apprach to economic policy. Thiscan only be provided only if the central bank is granted strong independence. Thus, crdiabilityenhances the effectiveness of monetary policy and central bank independence enhancescrdiability. Bank supervision and and independent central bank is another issue that subject to

debate in the context of designing an independent central bank is whether the function of banksupervision is part of the central bank or not. In most countries bank supervision is part of thejuridiction of the central bank, but in some the practice differs, In Germany, for example, banksupervision is not under the auspices of Bundesbank. The German view is that since the mainobjective of the bank is the attainment and maintenance of price stability, any otherconsideration, like those introduced by the responsibility of bank supervision which has to beconcerned with the stability of banking system, may compromise the main goal and, thereby,upset the focus of the central bank on price stability.

Recent discussions on constitutional political economy have been emphasised on the need for acentral that is independent of the executive (Cukierman 1992; Canzoneri, Grilli, and Masson

1992). The operation of central bank is usually established by the statute rather than by theconstititon. On might well as, therefore, whether independece is really possible in Parliamentarystystems, since the govrnment controls the legislature. The argument for an independent centralbank is the need to prevent the govrnment from engaging in highly inflatinary policies. Beacuseof the desire for re-election, for instance, the time horizon of the government might excessivelyshort. Even a government that tries to maximise the welfare of society rather than its ownpolitical fortune will run into problem of time inconsistancy (Kydland and Prescot 1977). If apolicy of no inflation is announced and the public believes it, the government has an incentive todeviate from it. Hence there is no need to to remove discretionary control over monetary policyfrom the government. Assuming constitutional law makers accept this premise, they might optfor rules rather than to discretion and write a specific monetary policy directly into law or

constitution. But a simple rule, while feasible, would provide too little flexibility for adjusting tounforseen events, while the rule that tried to specify optimal response to all contingencies wouldbe impossibly complex. Alternatively, policy makers may entrust fiscal discretion to anindependent central bank rather than to the government. Information do suggest that countrieshave adopted different measures to ensure the real indepence of the governor of the bank.


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Box 1: Summary of Best Practices on Central Bank Independence and Accountability

Criteria Best practices

Clarity ofObjectives

Establish a single of primary objective in terms of preserving price stability. Ifthere are multiple of objectives (for example, price stability and financial systemstability), any policy conflict that arises should be resolved in favor of price

stabilityPoliticalautonomy

Central Banks Board of Directors must be nominated and appointed by thegovernment and Congress in a two-step process, without any representation ofthe government or the private sector. They should be appointed for term longerthan that of the presidential term, and grounds for dismissal should be solely ofa legal nature and clearly established in law. Although the central bank Board ofDirectors itself or the government should take initiative for the dismissal of aboard member, the Legislature or the Judicial Branch should bear the finaldecision.

Economicautonomy

Provide central banks with instrument independence, that is, the freedom to use allthe means to achieve the inflation target. Interest rate policy should be theexclusive responsibility of the central bank, while the selection of the exchange

rate regime may be shared with the government, such that it does not interferewith the conduct of monetary policy and the achievement of the policy target.Goal independence, for example defining unilaterally an inflation target, implies astronger independence but assigns the central bank the responsibility of drivingthe short-run trade-off between inflation and unemployment, which is more inthe nature of the political authorities decision. Direct credit to the governmentshould be prohibited or carefully limited in line with the policy objective.

Financialautonomy

Define clear rules governing the relationship between the central bank and thegovernment in the treatment of central bank losses and profits. Governmentshould commit to maintain central banks capital such that monetary policy isimplemented without financial restrictions and focused on established policyobjectives, while central bank profits should be transferred to the government

after an appropriate accumulation of central banks legal reserves.Accountability The central bank should report to the government and the Legislature on theconduct of monetary policy, and in particular on the achievement of the long-run inflation policy and the implementation of actions and policies to that end.Such reports should be given broad public dissemination. Financial statementsshould be published at least once a year under generally accepted accountingprinciples, and should be certified by an independent auditor. Summary balancesheets should be published more frequently under similar accounting standards,supplemented with relevant explanatory notes.

Luis I. Jacome H, (2001): Legal Central Bank Independence and Inflation in Latin America : IMF Working Paper, Monetary and Exchange Affairs WP/01/212

Box 2. Central Bank involvement in banking crises resolution (Selected country cases in Latin America)


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Ecuador(1998-1999)

The banking crisis of 1998 and 1999 led to the closure, or the taking over by the State, of16 banks (65 percent of total assets), including four of the five largest banks. The CentralBank of Ecuador (CBE) was actively involved in this crisis, initially through LOLRfacilities, and subsequently via the payment of deposit guarantee claims. In return, the CBEreceived fixed assets and the lending portfolios of those institutions, as well as government

paper. As a result, the CBEs assets Grew by a factor of 12 between 1997 and 1999. Thesize of the crisis made it impossible to sterilize monetization in full, and control overmonetary policy was therefore lost. CBEs financial statements did not show lossesassociated with these transactions because the CBE charged a penalty interest rate on itsliquidity loans and because government paper was discounted at market values. However,provisions stemming from bad loans were not made in accordance with internationalstandard, and thus its balance sheet does not reflect its true financial position.

EL Salvador(1998)

During the Credisa Bank crisis- a medium-sized financial institution the bank initiallyreceived liquidity loans from the Central Reserve Bank (CRB), which then got involved insolving the crisis. As part of the banking resolution strategy, the CRB made a swap,providing liquid assets to the four acquiring banks of Credisas deposits and receivingCredisas impaired assets. The CRB sterilized monetization by issuing long-term paper that

was purchased by the four banks, and used them to comply with central bank reserverequirements. The CRB has begun to liquidate the acquired assets, but losses will not beabsorbed by the CRB, as initially planned, because the recent adoption of dollarizationrequires the cleaning of the CRBs balance sheet.

Guatemala(2001)

The cost of intervention of three small banks (about 6 percent of total deposits) has beenabsorbed for the time being by the Bank of Guatemala (Banguat), with no governmentinvolvement. Earlier, Banguat provided liquidity loans against assets of the three problembanks. After intervention took place, the Monetary Board authorized Banguat to extend aline of credit to the intervened banks to pay their obligations, primarily to depositors. Thesefunds were provided without receiving any collateral in exchange. Since the crisis was ofminor dimensions, Banguat sterilized monetization through OMOs. Banguat willpresumably absorb the losses that will be generated when the three banks are liquidated, asthe government has no legal requirements to compensate central bank losses. However todate Banguat has made no provisions to cover such losses.

Venezuela(1994)

The systemic banking crisis in Venezuela required an intensive involvement of the centralBank of Venezuela (CBV). After the collapse of Banco Latino the countrys secondlargest bank- another 12 banks were subsequently taken over by the State or closed in 1994and 1995. The CBV provided LOLR resources directly to a number of institutions orindirectly via the deposit insurance fund (FOGADE) initially at market interest rates andlatter at below market conditions. In return, the CBV received assets of the problem banksand claims on FOGADE, which did not fully cover the emergency assistance provided.Sterilization inflicted a high cost to the CBV and in the end was insufficient to completelyabsorb the excess liquidity. As of today, government obligations to the CBV has not beensettled down. In the mean time, the government has been covering only marginally CBVsclaims, while at the same time it has extracted from the CBV significant resources to

finance public expenditure stemming from CBVs unrealized accounting profits.Luis I. Jacome H, (2001): Legal Central Bank Independence and Inflation in Latin America : IMF Working Paper, Monetary and Exchange

Affairs WP/01/212


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Table 1. Index of Central Bank Independence and accountability (Criteria, Values, and weights)Criteria (Weight) 1 0.5 0

1. Central BankObjective (2)

Preserving price stability isthe single objective. Ifmore than one conflictingobjective, price stability

has priority.

Multiple conflictingobjectives withoutestablishing thatpreventing price stability

has priority.

Multiple objectives,including growth, anorderly development, oreconomic development,

without priorities.2. Appointment andterm of office of themembers of theCentral Bank Board(2)

Nominated (appointed) bygovernment andappointed (confirmed) byCongress. Term in officeexceed or overlapgovernment period.

Nominated and appointedin a two-step process forsame term in office thangovernment withoutoverlap, or directly forlonger term.

Appointed directly by thegovernment for the sameor shorter period than thegovernment.

3. Structure ofCentral Bank Board(2)

No private sector andgovernmentrepresentatives, exceptMin. of Finance withoutvote.

Direct governmentrepresentation, includingMinister of finance withvote.

Direct government plusprivate sectorrepresentatives (bankers,entrepreneurs, etc)

4. Removal of

Board Members (2)

Two- step process, with

qualified majority understrictly legal grounds. Finaldecision by Congress ofJudicial Court

Directly by the Executive

branch under strictly legalgrounds, or in two-stepprocess under non-legalbasis.

Removal by the Executive

branch for subjective orpolitical-not legal grounds,or by the private sector.

5. Central Bankcredit togovernment (3)

No direct credit, except inclearly regulatedemergency situations. Orthrough the secondarymarket, with limitations.

Direct credit with limits,via secondary marketwithout limits, throughoverdrafts, or indirectly viapublic banks.

Direct or indirect creditwithout limits.

6. Lender-of-last-resort (2)

Emergency loans legallyregulated, including limitsto the amount to begranted.

Emergency loans legallyregulated, without limits tothe amount to be granted.

Discretionary policy foremergency loans andprovisions for bankresolution.

7. Instrumentsindependence inthe conduct ofmonetary policy (3)

Total independence in theuse of monetaryinstruments.

Government involvementin formulation ofmonetary and exchangerate policy.

Limitations on the use ofmonetary instruments(reserve requirements,interest rates).

8. Financialindependence (1)

Government assurescentral bank capitalintegrity. Central banktransfers profits to thegovernment after properprovisioning.

Government not requiredto assure integrity ofcentral bank capital.External approval ofCentral Bank budget.

Central bank conductsquasi-fiscal operations. Nogovernment capitalizationrequired.

9. Accountability (1) Central Bank Governorappears before Congressand reports to

government. Reportdisclosed on a timely basis.

Reports only to thegovernment on a regularbasis or when there are

monetary disturbances,plus an annual report.

Central bank onlypublishes an annual report.

10. Transparencyand disclosure offinancial statements(1)

Publishes periodicallyfinancial statementscertified by an externalauditor.

Publishes financialstatements with theapproval of a public sectorauditor.

Inappropriate accountingprocedures. Publishesfinancial statements withthe seal of internal auditor.



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Table 3. Central Bank Independence and Accountability ( Country evaluation)

Criteria (Weight) 1 0.5 0

1. Central BankObjective (2)

Argentina, Bolivia, Brazil,Chile, Colombia, CostaRica, Honduras, Mexico,

Peru

Paraguay, Uruguay Dominican RepublicGuatemala, Venezuela

2. Appointment andterm of office of themembers of the CentralBank Board (2)

Argentina, Bolivia, Brazil,Chile, Colombia, CostaRica, Mexico, Paraguay,Venezuela

Peru, Uruguay Dominican Republic,Guatemala, Honduras

3. Structure of CentralBank Board (2)

Argentina, Bolivia, Brazil,Chile, Honduras, Mexico,Paraguay, Uruguay

Brazil, Colombia, CostaRica, Venezuela

Dominican Republic,Guatemala

4. Removal of BoardMembers (2)

Argentina, Chile,Colombia, Dominican,Republic Honduras,Mexico, Peru

Bolivia, Costa Rica,Paraguay

Brazil, Guatemala,Uruguay, Venezuela

5. Central Bank creditto government (3) Argentina, Chile,Guatemala, Mexico, Peru,Venezuela

Bolivia, Brazil, Colombia,Costa Rica, DominicanRepublic, Honduras,Paraguay, Uruguay

6. Lender-of-last-resort(2)

Argentina, Peru, Uruguay Costa Rica, Colombia,Honduras, Mexico

Bolivia, Brazil, Chile,Dominican Republic,Guatemala, Paraguay,Venezuela

7. Instrumentsindependence in theconduct of monetary

policy (3)

Argentina, Bolivia, Brazil,Chile, Colombia, CostaRica, DominicanRepublic, Guatemala,Honduras Peru, Uruguay

Mexico, Paraguay,Venezuela

8. Financialindependence (1)

Colombia, Peru Argentina, Bolivia, Brazil,Chile, Costa Rica,Guatemala, Honduras,Mexico, Paraguay,Uruguay, Venezuela

Dominican Republic

9. Accountability (1) Argentina, Bolivia, Brazil,Chile, Colombia,Honduras, Mexico,Uruguay, Venezuela

Costa Rica, DominicanRepublic, Guatemala,Paraguay, Peru

10. Transparency anddisclosure of financialstatements (1)

Argentina, Brazil, Chile,Mexico

Bolivia, Colombia,Paraguay, Peru, Uruguay,Venezuela

Costa Rica, DominicanRepublic, Guatemala,Honduras


Structure of Central bank


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In many countries constitution is not of course the place to regulate in detail central bank issues,and some countries do not even mention it in their acts at all, but the majority of Europeanconstitutions were written when central banking was not considered so important and anindependent aspect of the national financial system as it now. Poland (1992) gave constitutional

support to the regulation of the Ploish central bank is considered important to overcome ahistorically rooted consciousness which still exists from when the central of Poland wsfunctionally a part of Ministry of Finance. This experience coexists with the present lack ofunderstanding and acceptence by a large part of society and by many politicians of the role ofmodern central bank.

The central bank of Norway, created in 1816, was located in Trondheim, several hundred milesfrom the capital and from the seat of the government. In countries with dual executive, thecentral bank governor may be appointed by the president rather than by the government, onassumption that governor would than be more likely to be conservative than activist, that is, toplace greater weight on pricce stability than on employment. The constitution may also explicitlyforbid the government from instructing the bank or require that it make its instructions public.

Furthermore, price stability may be constitutionalised as the goal of the central bank. One mayalso try to strengthen the bank by taking away some of its power following the sprit of Schelling(1960). To protect the bank from informal pressure from the government, therefore, the bankcould be explicitly forbidden from engagging in dificit funding.

Grill, Masciandro and Tabellini (1991) Index of Political Independence

Political Independence Yes No1 Governor not appointed by the government2 Governor appointed for more than 5 years3 Board members are not appointed by the government4 Board members are appointed for than five years

5 No government official represent at the Board

6 No government approval of monetary policy is required7 Is the bank required to pursue monetary stability8 Are there legal provisions that strenghten banks position in case of conflict with

governmentOverall index of Political Independence (8) and actual score of Bangladesh

Economic Independence Yes No

1 Is the direct credit facility not automatic2 Is the direct credfacility based on the market interest rate3 Is the direct credit facility temporary

4 Is the direct credit facility of limited amount

5 Does the central bank not participate in th eprimary market for public debt6 Is the discount rate determined by the central bank7 Is the supervision not entrusted to the central bank8 Is the banking supervision not entrusted to the central bank aloneOverall index of Political Independence (8) and actual score of Bangladesh


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Alesina and Grill Index (1992)

Political Independence Yes No1 Governor not appointed by the government2 Governor appointed for more than 5 years3 Board members are not appointed by the government

4 Board members are appointed for than five years5 No mandatory participation of government representative in the Board6 No government approval of monetary policy is required7 Statutory requirement that central bank pursues monetary stability8 Explicit conflicts with the government is not possibleOverall index of Political Independence (8) and actual score of Bangladesh

Economic Independence Yes No

1 Direct credit facility not automatic2 Direct credit facility - on the market interest rate3 Direct credit facility- temporary4 Direct credit facility- limited amount5 Central bank does not participate in th eprimary market for public debt

6 Discount rate set by the central bank7 No portfolio constraints8 No credit ceilingOverall index of Political Independence (8) and actual score of Bangladesh

Bade and Parkin Indices of Political IndpendenceCentral bank is thehighest monetary policyauthority

No governmentmembers on the centralbank council

Some members of centralbank council are appointedidependent from thegovernment

Degreeof PoliticalIndependence

Not true Not true Not true 1Not true True Not true 2 True True Not true 3 True True True 4

Bade and Parkin Indices of Financial IndpendenceBudgetary Independence Salries of central bank are

determined by the centralbank

Allocation of profit isdetermined by the centralbank

Degree of FinancialIndependence

Not true Not true Not true 1 True Not true Not true 2 True True Not true 3 True True True 4

Eijffinger and Schaling Indicator of Central Bank Independence (1993)Central bank is the sole

and final policy authority

No government official

on Bank Board

Some Board

appointments ofGovernment

Degree of policy

Independence

Not true Not true Not true 1Not true True Not true 2Bank- Government True Not true 3 True True Not true 4 True True True 5


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Variables for Legal Central Bank Independence- Cukierman, Webband Nayapati (1992)

VariableNumber

Description of Variables Weight NumericalCoding

1 Chief Executive Officer 0.20a. Term of office

Over 8 years6 to 8 years5 Years4 YearsUnder 4 years at the discretion of the appointing authorityb. Who appoints CEO

Board of Central BankA council of the central bank board, executive branch, and legislative branchLegislature Executive collectively (council of ministers)One or two members of the executive branchc. Dismissal

No provision for dismissalOnly for reasons not related to the policy

At the discretion of the central bank boardAt legislatures discretionUnconditional dismissal possible by executive

At exectives discretionUnconditional dismissal possible by executived. May CEO hold other offices in government?

NoOnly with permission of executive branchNo rule against CEO holding another office

2 Policy formulationa. Who formulates monetary policy

Bank aloneBank participates, but has little influenceBankonly advises governmentBank has no sayb. Who has word in resolution of conflict?

The bank, on issues clearly defined in the law as its objectivesGovernment, on policy issues not clearly defined as banks goal or in case of conflict

withinh the bank

A council of central bank , executive branch, and legislative branchThe legislature, on policy issuesThe executive branch on policy issues, subject todue process and possible protest by thebank

The executive branch has unconditional priorityc. Role in the governments budgetary process

Central Bank activeCentral bank has no influence

3 Objectives

Price stability is the only objective in the charter, and central bank has the final word incase of conflict with other government objectivesPrice stability is the only objective

Price stability is one goal, with other compatable objectives, such as stable bankingsystemPrice stability is one goal, with potentially conflicting objectives, such as full employment

No objective stated in the bank charterStaed objective do not include price stability


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Variables for Legal Central Bank Independence- Cukierman, Webb and Nayapati (1992)

VariableNumber

Description of Variables Weight NumericalCoding

4 Limitation on lending to governmenta. Advances (limitation on nonsecuritised lending)

No advance permittedAdvance permitted but with strict limits (up to 15% of government rvenue)Advance permitted, and limits are loose (over 15% of government revenue)No legal limits on lendingb. Securitized lendings

Not permittedPermitted,but with strict limits (up to 15% of government rvenue)Permitted, and limits are loose (over 15% of government revenue)No legal limits on lendingc. Terms of lending (maturity, interest, and amount)

Controlled by the bankSpecified by the bank charter

Agreed by the central bank and executiveDecided by the executive branch aloned. Potential borrowers from the bank

Only central government

All levels of government (state as well as central)Those mentioed above and the public enterprisePublic and private sectore. Limits on central bank lending defined in

Currency amountsShare of cenbank demand liabilities or capitalShares of government revenuesShares of government expendituresf. Maturity of loans

Within 6 monthsWithin 1 yearMore than 1 yearNo mention of the maturity in the lawg. Interest rate on loans must be

Above minimum ratesAt market rates

Below maximum ratesInterest rate is not mentionedNo interest on government borrowing from the central bankh. Central bank prohibited from buying or selling government securities in the

primary market?

YesNo


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Indexes Romania Czech Republic Poland Bulgaria Bangladesh

Legal Status Not registered as StateOwned Enterprise

Created by Lawof Parliament

Created byOrdinance

Opering levels (i)Head Quarter(ii) Branch in all countrycapital(iii) Subsidiary in mostimportant cities

Head office andSeven regional officesand several specilisedoperational units

Head Office dividedinto functionaldepartments, 13 regionalbranches of moredeveloped acitivity and

36 localbranches oflimited activity

Head offcie atDhaka and 8branch offices atdifferent part ofthe country

Appointmentof Board

Parliament onrecommendation of PrimeMinister 9 membersBoard is appointed

President of theRepublic

Diet and the Senatebased on propsal of thePresident

Parliament andthe President

Ministry ofFinance andPolitical Party inpower

Governmentofficials at theBoard

One member withoutvoting right

Governor, oneDG nominatedby Govt, fourDirectors(professional)Nominated bythe Govt, fourgovt officials

Tenure of theBoard

initially 8 years now 5 years 6 Years 6 years term Governor andthe Head of issue

department 6years, head ofaudit 4 andbanking 2 years.Membersappointed by thePresident start

with mandate of5, 3 & 1 year.

Within one yearpolitical andgovernmentalindepence ofeach member isevaluated.

On the desire ofthe Ministry of

Finance and Partyin power

Structure of theBoard

President as Governor (1) Vice Governor as Vice-

President (1)Vice Governors (2)Non-executive memebrs(5)

Governor (1)Vice-Governor (2)

Senior Executivemembers (4)

Council of monetaryauthority consists with

Chairman (Governor)and nine members

where nominations aremade by President:3,Diect:3 and by theSenate:3

Director (1) ViceDirector (3)

Other members(3)

Governor, 4 dygovernors (1

from privatesector),executiveDrector (7),GeneralManager (30plus)


Appointmentof Governor

Parliament President of theRepublic

Diet, Senate andPresident

ParliamentappointsDirector (1) and3 Vice Directors,the Presidentappoints 3 other

Directors

Ministry ofFinance andPolitical regimeom power

Recall of Boardor any memberof the Board orGovernor

Parliament President of theRepublic

Senate but governor canonly be recalled at theend of the term.

Ministry ofFinance andPolitical regimein power

Restrictions onmaximum yearsof service

Not defined Not defined Same person can notcontinue longer than 2consequtive term (12years)

Decided by theMinistry ofFinance andPolitical regimein power

Politician or Restricted Allows one member One council of Shadow of


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Parliamentmembersrepresntation atthe Board

ministers allowedwithout voting right butrifght to submitproposals

Politician s canrepresent

BudgetPreparation

It is ia position of ofan entrepreneour inrespect of dealing

with its property andnot paid from statebudget

Prepared by the centralbank approved by theCouncil of Monetary

Policy

Prepared by theBB andapproved by

the Ministry ofFinance

Operatingdepartments

Strategy, ForeignExchange, MonetaryOperation, Regulation andSupervision, Payment-Clearing and risk,

Treasury, Accounting-ITand Statistics, SecretaryGeneral, and Logistics

Secretariat of theGovernor-PublicRelation andOrganisationdepartment; RegionalBranch Offices-LegalServices-Internal

Audit and Currency;Monetary-Statisticsand Budget; Banking

Transaction and andRisk Management;

(i) IssueDepartment(ii)BankingDepartmentBank SupervisionDepartment

(i) IssueDepartment(ii)BankingDepartment

Economists and practitioners in the area of monetary policy generally believe that the degree ofindependence of the central bank from other parts of the government affects the rates ofexpansion of money and credit and, through them, important macroeconomic variables, such asinflation and the size of the budget deficit.

Summary

There are two conncepts of independence. One focusses on goal indpendence and the other oninstrument independence. The goal independence is found for example in the German case inwhich the Bundesbank does not get any instruction from the government. The Bundesbank setsits own goal and then uses the available instruments in order to meet the goal. With instrumentindependence, the tragets are set by the government and the central bank is completely free touse the policy instrument at its disposal in order to meet the assigned target. In addition, centralbank is free from any obligation to finance the governments budget. The complete separationbetween the policies of the central bank and the budgetary needs of the government, is put inorder to ensure that the intrinsic governments inflation bias does not result in an actual inflationbias. In addition to the distinction between goal and instrument indpenednece, the very conceptof central bank independence requires further classification. One needs to distingush betweenlegal indendence that can be inferred from the language of of the law, and actual indendence thatdepends on the actual practice and on the way in which law is being interpreted andimplemented. For example, in many developing countries, it is difficult to assess the actual

degree of central bank indpendence from analysing only the language of central bank law,because the text of the law is convincing, but record of implementation is not. In othercountries, on the otherhand, the provisions contained in the formal central bank law are notstrong but yet, the actual degree of indpendence is nevertheless impressive. It is argued that theissue of central bank independence is not just a juridical issue but rather, it is a practical one.


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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, over 30 central bank laws were revised, were rewritten, and allin one direction, namely strengthening the independence of the Central Bank. Several reasonsunderlie the movement towards strengthening Central Bank independence. First, countries thatwere successful in maintaining low inflation have typically enjoyed better economic performancethan countries that were unable to control inflation. Second, the world has undergone aconceptual revolution. In contrast with previous beliefs, the experience of the 1960s and 1970shas 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 basisby creating inflation. Attempts to exploit this trade-off have failed and have resulted indisappointment, frustration, and costly economic distortions. The conceptual revolution hasyielded the conclusion that price stability contributes to good economic performance whileinflation 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 inthe market economy. There is now growing skepticism about the effectiveness of centralplanning. There is also skepticism about the capacity and the ability of governments to beeffective participants in the market place. There is a growing conviction that free enterprise ledby the private sector is the best framework within which one can generate investment andsustainable growth. Finally, there is also a growing conviction that in order to promoteinvestment and growth one needs to generate price stability. Thus, the new view about the roleof government and the desire to promote sustainable growth within a market economy broughtabout renewed interest in the conditions necessary for price stability. There have also been fourimportant historical developments that took place in the past few years and that contributed tothe growing interest in Central Bank independence. First, the creation of the European Union

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, theCentral Bank must be independent, and its main objective must be price stability; the Bank mustkeep 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 Banklegislation 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 withthe topic of Central Bank independence.

The second development that stimulated interest in the subject was the urgent need to createseveral new Central Banks due to the collapse of the Soviet Union that brought about the

creation of independent Republics. These Republics have realized the need to have a newCentral Bank that is independent. The third development arose from the experience of severalcountries in Latin America that recognized that their suffering from high inflation was associatedwith having weak, and not sufficiently independent Central Banks. The fourth development hasbeen the emergence of globalized capital markets. More and more countries have realized thatin order to succeed in the new highly competitive global environment, countries must be held inhigh regard by the various rating agencies that grade the economies' risk. These ratings dependheavily on the countries' track record of fighting inflation and on the institutional setting thatgoverns the economic policy making process. Therefore, the conclusion that has emerged is that


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a country that wishes to maintain access to the international capital market must aim at achievingprice stability and must exhibit a good inflation track record. In addition, it must also have theappropriate institutional and legal framework that underlie the policy making process.Prominent among such institutions is the presence of a independent Central Bank. It is arguedthat 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. Following arecriteria developed under different heading of independence for a central bank.

Political Independence:The central Bank Independenceinclude, among others,Governor notappointed by the government, Governor appointed for more than 5 years; Board members arenot appointed by the government; Board members are appointed for than five years; Nomandatory participation of government representative in the Board; No government approvalof monetary policy is required; Statutory requirement that central bank pursues monetarystability and explicit conflicts with the government is not possible.

Economic Independence include, direct credit facility not automatic; direct credit facility - onthe market interest rate; direct credit facility- temporary; direct credit facility- limited amount;

Central bank does not participate in the primary market for public debt; discount rate set by thecentral bank and no portfolio constraints and no credit ceiling.

Financial Independence includes, Budgetary Independence; salaries of central bank aredetermined by the central bank; allocation of profit is determined by the central bank; degree ofFinancial Independence can be assessed considering these variables.

Assessment of Independence: Questions those should be examined in assessing central bankindependence include about the length of the term of the governor; about the dependence ofthis term on the timing of changes in governments; does the new government have the power toreplace 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 Board? How many of the Boardmembers should be insiders, how many outsiders? Can the members of the Board earn salariesfrom other sources? Who determines the budget of the central bank? What happens when thereis 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 itneed to get government approval at each case? In what way and to whom is the bankaccountable? Who appoints auditor of the bank and the remuneration thereof? Whoauthenticates reliability check of FDI figures? and to whom the central bank reports-whether tothe ministry of finance, to the president or to the parliament?

Bangladesh Bank: The Bangladesh Bank Order of 1972 resembles legacy of former PakistanCentral Order drawn in 1950s. This does not provide any of the practicing independenceassessment criteria applicable for an efficient central bank compatible for operation of marketeconomy because of open and hidden political interference since the independence of thecountry. In the recent time a namesake amendment of central bank order was made by theprevious government, which does not indicate any change. The nine member Board includeGovernor, Deputy Governor-1, 3 GoB officials and 3 GoB nominated persons. The Co-ordination Council is chaired by the Finance Minister, other members are Commerce Minister,Governor, Finance Secretary, Secretary IRD, and a member of planning commission.


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Central Bank Independence Index constructed based on 8 different criteria by Alesina and Grill(1992) on plitical, economic, and 4 criteria by Bade and Parkin Indices of Financial Indpendence(1992) once compared with the Bangladesh Bank Order indicate that these do not meet thequalifying criteria for an independent central bank. Under section 9(3) (d) of Bangladesh BankOrder, the government has the authority to appoint 3 government officials at the Board which

is in addition to 4 directors from outside which historically proven to be political appointment.The length of service of governor have been lower than the best practice and those followed inthe Asian neighbors. The current governor joined in his job in Feb 2005. During 1972-2007highest length of service of a governor was 11 years (between 1976-87) while the second highestwas 5 years. Four govenors served 4 years each, one 3 years and other served lowest 2 years.Compared to international best practices only one governor completed more than 6 years.Morover, there was no stability on the tenure of govrnor, deputy governor (s) and thedirector(s) of Bangladesh Bank. Under articles 10(9), 15(1) (a) and 15(1) (b) continuation of theposition of governor, deputy governor(s) and director(s) depends on the pleasure of thegovernment i.e practically, on the desire of Finance Ministry and party in power. Moreover,section 10(10) authorised government to grant leave to the governor and deputy governor(s) forany period of time as desired by the Finance Ministry. This arbitry power was misused at several

ocasions, by transfering them to other places. This most striking example was the case of deputygovernor Mr Ruhul Amin who was granted forced leave on difference opinion with the FinanceMinister of last government. Section 9A authorizes Co-ordination Council to coordinate themacro economic framework including fiscal, monetary and exchange rate policy, finalize publicsector borrowing which works as hindrance to ensure consistency among marcoeconomictargets. Article 82(2A) states that salary and compensation package of employees would besubject to approval of government which also work as an obstacle on reward, punishment, andemployee motivation. Section 65 defines the prodecure of appointing external auditors by theGoB which in other countries are done by the Board and the audit fee of Bangladesh Bank isnegligible Tk 0.03m divided between two firms compared to Pakistan Rs 2.5 m and India Rs4.5m. This indicate the current state of corporate governance within the central bank of

Bangladesh. For transparency and corporate governance these provisions needs be deleted fromthe statute.

Time has come now when a truly non-party caretaker government is running the administrationof the country who can f rm a Task Force to make recommendation to the government for theIndependence of Bangladesh Bank compatiable to promote and facilitate ongoing economicliberalization towards market economy. The Terms of Reference of the proposed committeeshould atleast cover, examine the central bank charter of 2 from neghoboring, one from WesternEurope, one from Eastern Europe and one from Latin America and compare those with that ofBangladesh Bank Order. Recommend, the ways and means to ensure minimum reqiurement ofindependence criteria to ensure the terms of appointment of governor and deputy governor,

restructuring the Board, free from political pressure, redefine the Terms of Reference of of theBoard of Directors, and ensure legal operational, economic and financial independence.Professional bodies dealing with economy, business, industry and trade should raise their voiceto ensure independence of Bangladesh Bank to facilitate and promote Bangladesh economyfrom state to market.


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Bad, R. and M. Parkin (1988), Central Bank Laws and Monetary Policy, mimeo, University ofWestern Ontario.

Barro, R.J. (1995), Inflation and Economic Growth, Bank of England Querterly Bulletin 35,166-76.Barro, R.J. and D.B. Gordon (1983), Rules, Discreation, and Reputation in a Model of Menetary

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Mass.: MIT Press.Cukierman, A., Webb, S. B. And B. Neyapti (1992), Measuring the Independence of Central

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Eijffinger, S.C. W. And J. De Haan (1996), The Political Economy of Central-BankIndependence, Special Papers in International Economics No.19, Parinceton, New

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Fischer, S. (1995a) Central Bank Independence Revisited, American Economic Review 85,Papers and Proceedings, 201-6.Fischer,S. (1995b), The Unending Search for Monetary Salvation, in: Bernanke, B.S. and J.J.

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