Activist countries

Africa: Developing countries need monetary financing

Sydney and Dakar — Developing countries have long been told to avoid borrowing from central banks (CBs) to finance government spending. Many have even legislated against BC funding of tax expenditures.

Central bank fiscal financing

Such laws are supposed to be necessary to curb inflation – below 5% or even 2% – in order to accelerate growth. These provisions have also limited a potential developmental role of the CB and the government’s ability to better respond to crises.

Better coordination of monetary and fiscal policies is also needed to achieve the desired structural transformation, especially in decarbonizing economies. But too many developing countries have tied their hands with restrictive legislation.

A few have pragmatically suspended or otherwise circumvented these self-imposed bans. This allowed them to borrow from OCs to fund pandemic relief and recovery programs.

These recent changes have reopened debates on the urgent need for coordination of countercyclical and developmental fiscal and monetary policies.

Monetary funding wiped out

But financial interests argue that this allows national CBs to finance government deficits, i.e. monetary financing (MF). The MF is often blamed for fostering public debt, balance of payments deficits and runaway inflation.

As William Easterly has noted, “Fiscal deficits were largely responsible for the various economic ills that afflicted developing countries in the 1980s: over-indebtedness and debt crisis, high inflation and poor investment performance and growth. “.

Therefore, calls for MF are generally met with skepticism, if not outright opposition. The MF undermines central bank independence (CBI) – hence the strict separation of monetary authorities from fiscal authorities – supposedly necessary to prevent runaway inflation.

A recent study by the International Monetary Fund (IMF) insists that MF “involves considerable risks”. But he recognizes that MF to deal with the pandemic has not jeopardized price stability. An article by the Bank for International Settlements also revealed that the MF allows developing countries to respond in a countercyclical way to the pandemic.

Cases of MF leading to runaway inflation have been very exceptional, for example in Bolivia in the 1980s or in Zimbabwe in 2007-08. These were often associated with the collapse of political and economic systems, such as during the collapse of the Soviet Union.

Bolivia has suffered major external shocks. These included Volcker’s interest rate spikes in the early 1980s, greatly reduced access to international capital markets, and the collapse of commodity prices. The political and economic conflicts in Bolivian society did little to help.

Similarly, Zimbabwe’s hyperinflation was partly due to disputes over land rights, aggravated by the government’s mismanagement of the economy and British-led Western efforts to undermine the Mugabe government.

Indian lessons

Former Reserve Bank of India Governor YV Reddy noted that fiscal-monetary coordination had “provided funds for the development of industry, agriculture, housing, etc. through the through development finance institutions” in addition to allowing SOEs to borrow (EP) in the early decades.

For him, the less satisfactory results – for example, the persistence of “macro-imbalances” and the “automatic monetization of deficits” – were not due to “fiscal activism per se but to the soft budget constraint” of companies and “persistently insufficient returns” from public investment. .

Monetary policy is constrained by large and persistent budget deficits. For Reddy, “there is no doubt that the nature of the interaction between [fiscal and monetary policies] depends on the specific country situation”.

Reddy urged addressing monetary and fiscal policy coordination issues within a broad common macroeconomic framework. Several lessons can be drawn from the Indian experience.

First, “there is no ideal level of budget deficit, and the critical factors are: how is it financed and what is it used for?” There is no alternative to the efficiency of public enterprises and the financial viability of public investment projects.

Second, “public debt management, in countries like India, plays a critical role in the development of domestic financial markets and hence in the conduct of monetary policy, including for effective transmission”.

Third, “smooth policy implementation may require that one policy does not unduly overload the other for too long”.

Lessons from China?

Zhou Xiaochuan, then Governor of the People’s Bank of China (PBoC), highlighted the multiple responsibilities of CBs – including financial sector development and stability – in transition and developing economies.

The Chinese CB official noted that “monetary policy will undoubtedly be affected by international balance of payments and capital flows.” Thus, “macroprudential and financial regulation are sensitive mandates” for CBs.

The goals of the PBoC – long mandated by the Chinese government – ​​include maintaining price stability, stimulating economic growth, promoting employment and addressing balance of payments issues.

Multiple objectives required more coordination and joint efforts with other government agencies and regulators. Therefore, “the PBoC … works closely with other government agencies.”

Zhou acknowledged that “it is difficult to strike the right balance between multiple objectives and the effectiveness of monetary policy.” By maintaining close ties with the government, the PBoC facilitated the necessary reforms.

He also stressed the need for appropriate policy flexibility. “If the central bank only focused on keeping inflation low and did not tolerate price changes during price reforms, it could have stalled overall reform and transition.”

During the pandemic, the PBoC has developed “structural monetary” policy tools, intended to help sectors affected by Covid. Structural tools have helped maintain ample interbank liquidity and support credit growth.

More importantly, its targeted monetary policy tools were increasingly aligned with the government’s long-term strategic objectives. This includes supporting desired investments, for example in renewable energy, while avoiding asset price bubbles and “overheating”.

In other words, the PBoC coordinates monetary policy with fiscal and industrial policies to achieve the desired stable growth, thereby boosting market confidence. As a result, inflation in China remained subdued.

Consumer price inflation has averaged just 2.3% over the past 20 years, according to The Economist. Contrary to global trends, consumer price inflation in China fell to 2.5% in August and only increased to 2.8% in September, despite its zero-Covid policy and measures such as containment.

Reforms needed

Effective coordination of fiscal and monetary policies requires appropriate arrangements. An IMF working paper showed that “neither legal independence of the central bank, nor a balanced budget clause or a rules-based monetary policy framework…is sufficient to ensure effective coordination of monetary policies. and budget”.

The appropriate institutional and operational arrangements will depend on the specific circumstances of each country, for example the level of development and the depth of the financial sector, as noted by Reddy and Zhou.

When the financial sector is shallow and countries need dynamic structural transformation, the establishment of independent fiscal and monetary authorities is likely to hinder, not enhance, stability and sustainable development.

Understanding each other’s objectives and operational procedures is key to establishing effective coordination mechanisms – both at the policy formulation and implementation levels. Such an approach should better ensure the coordination and complementarity needed to mutually reinforce fiscal and monetary policies.

Coherent macroeconomic policies must support the necessary structural transformation. Without effective coordination between macroeconomic policies and sectoral strategies, MF can aggravate payments imbalances and inflation. Macroprudential regulations should also avoid the negative effects of the MF on exchange rates and capital flows.

Unaccountable governments often take advantage of real, exaggerated, and imagined crises to pursue macroeconomic policies for regime survival and to benefit cronies and financial backers.

Undoubtedly, much better governance, transparency, and accountability are needed to minimize the immediate and longer-term damage from “leaks” and abuses associated with increased government borrowing and spending.

Citizens and their political representatives need to develop more effective ways to “discipline” policy making and implementation. This is necessary to secure public support to create fiscal space for responsible counter-cyclical and development spending.

IPS United Nations Office

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