Today, much of the developed world’s central banks are built after the “Bundesbank model.”
The model was born in post-World War I Germany after the country had been plagued with hyperinflation owing to financial indiscipline. The Deutsche Bundesbank was given full independence creating what is now known as the “Bundesbank model.”
The general aim of central banks under this framework is price stability and this is achieved by separating monetary policy from the grasp of political influence. Political business cycles occur when governments advocate populist and inflationary policies prior to re-elections in hopes of winning the popular mandate. Indeed, the empirical literature generally suggests that independent central banks are more effective at stabilising prices than their less-independent counterparts.
But in the wake of financial crises, central banks have received their share of scrutiny. We have been forced to question the effectiveness of central banks in an era where the Phillips Curve—positive relationship between inflation and employment—no longer holds. This implies that inflation accompanies recession and banks are forced to employ increasingly unconventional monetary policy.
Bank bailouts as a response to debt-default, possible conflicts of interest due to its dual role of setting monetary policy and supervisor, also has brought central banks’ credibility and independence into question.
How does this discussion bode for a developing country like Bangladesh?
In the Bangladesh context, it is not difficult to imagine the benefits of replicating the central bank models of the developed world, especially as it pertains to independence.
Our financial sector has been in doldrums with burgeoning NPLs (non-performing loans) and an over proliferation of banks. State-owned banks particularly remain a critical aspect of the NPL problem, with them being frequently recapitalised.
Currently, the Bangladesh Bank has limited operational independence and it is commonly speculated that licences for banks are granted and loans are approved due to political affiliations. The result is a culture of impunity where loan defaulters are not held accountable and political interference causes lax monitoring and supervision.
Yet it may be a mistake to treat the developed country framework as the universal cure for all nations. There are special considerations one should take into account for a developing country like Bangladesh. For one, financial markets including bond markets are in their nascent stage in Bangladesh.
In developed nations with mature bond markets, central banks engage in open-market operations to influence short-run interest rates and liquidity. In the absence of these options, central banks in developing economies would need to use other policy instruments and will thus have to coordinate with the government.
Moreover, central banks have a special role in the initial stage of a country’s development by promoting the country’s financial infrastructure. It can endorse inclusive growth by expanding banking operations to poorer populations. To improve access to credit in rural areas, central banks can, for example, fund cooperative credit societies on the basis of a proper impact study or sensitivity analysis.
Furthermore, one of the government’s major ambitions is to achieve Bangladesh’s transition to a middle-income country. A strict focus on price stability might not always be conducive to this. Chasing inflation targets can create a ‘contractionary bias’ where central banks may find their policies curbing growth.
In developing nations, monetary expansionary policies are more frequently needed to meet the credit demands of a growing economy. Low interest rates are necessary to encourage both private and public sector investment. Lower interest rates decrease the cost of servicing public debt, making financing economic development easier.
If we look to the example of South Korea’s development story, the central bank had limited independence and was driven heavily by the directives of the Ministry of Finance. This enabled the South Korean government to direct credit towards preferential sectors in line with wider economic goals.
To meet these macro-level aims, a synergy between monetary and fiscal policy must be maintained. Thus, complete independence from the government is thus neither feasible nor desirable, at least not at this stage of our development.
This is not to say we should disregard independence. Some form of institutional reform for the Bangladesh Bank is recommendable, particularly to ensure operational independence, so that day-to-day decisions are insulated from political interference. However, in terms of setting the wider agenda, coordinating with the central government is necessary at least in this stage of our development.
Separating the function of supervision and setting monetary policy to avoid conflicts of interest has been another key discourse occurring with regard to central banks. A central bank that performs both prudential supervision and decides monetary policy may have the incentive to set interest rates at very low rates to protect bank earnings, thus undermining price stability.
There have been suggestions that these functions be delegated to separate institutions or a ‘Chinese Wall’ be created within central banks. In Bangladesh, however, the functions of formulating monetary policy as well as supervising the banking sector falls to the Bangladesh Bank.
While there is a valid argument for separating these functions, there are notable disadvantages too. Playing the dual role gives central banks better access to information on the financial sector. This is invaluable to a developing country where information flows might not be as sound. Central banks playing both roles can also enable them to react to financial sector crises in a timely manner, especially in the developing economies.
The writer is an economic analyst.