Developing countries have long been told to avoid borrowing from central banks (CBs) to finance government spending. Many have even legislated against CB financing of fiscal expenditure.
Central bank fiscal financing
Such laws are supposedly needed to curb inflation – below 5%, if not 2% – to accelerate growth. These arrangements have also constrained a potential CB developmental role and government ability to respond better to crises.
Improved monetary-fiscal policy coordination is also needed to achieve desired structural transformation, especially in decarbonizing economies. But too many developing countries have tied their own hands with restrictive legislation.
A few have pragmatically suspended or otherwise circumvented such self-imposed prohibitions. This allowed them to borrow from CBs to finance pandemic relief and recovery packages.
Such recent changes have re-opened debates over the urgent need for counter-cyclical and developmental fiscal-monetary policy coordination.
Monetary financing rubbished
But financial interests claim this enables national CBs to finance government deficits, i.e., monetary financing (MF). MF is often blamed for enabling public debt, balance of payments deficits, and runaway inflation.
As William Easterly noted, “Fiscal deficits received much of the blame for the assorted economic ills that beset developing countries in the 1980s: over indebtedness and the debt crisis, high inflation, and poor investment performance and growth”.
Hence, calls for MF are typically met with scepticism, if not outright opposition. MF undermines central bank independence (CBI) – hence, the strict segregation of monetary from fiscal authorities – supposedly needed to prevent runaway inflation.
Recent International Monetary Fund (IMF) research insists MF “involves considerable risks”. But it acknowledges MF to cope with the pandemic did not jeopardize price stability. A Bank of International Settlements paper also found MF enabled developing countries to respond countercyclically to the pandemic.
Cases of MF leading to runaway inflation have been very exceptional, e.g., Bolivia in the 1980s or Zimbabwe in 2007-08. These were often associated with the breakdown of political and economic systems, as when the Soviet Union collapsed.
Bolivia suffered major external shocks. These included Volcker’s interest rate spikes in the early 1980s, much reduced access to international capital markets, and commodity price collapses. Political and economic conflicts in Bolivian society hardly helped.
Similarly, Zimbabwe’s hyperinflation was partly due to conflicts over land rights, worsened by government mismanagement of the economy and British-led Western efforts to undermine the Mugabe government.
Indian lessons
Former Reserve Bank of India Governor Y.V. Reddy noted fiscal-monetary coordination had “provided funds for development of industry, agriculture, housing, etc. through development financial institutions” besides enabling borrowing by state owned enterprises (SOEs) in the early decades.
For him, less satisfactory outcomes – e.g., continued “macro imbalances” and “automatic monetization of deficits” – were not due to “fiscal activism per se but the soft-budget constraint” of SOEs, and “persistent inadequate returns” on public investments.
Monetary policy is constrained by large and persistent fiscal deficits. For Reddy, “undoubtedly the nature of interaction between [fiscal and monetary policies] depends on country-specific situation”.
Reddy urged addressing monetary-fiscal policy coordination issues within a broad common macroeconomic framework. Several lessons can be drawn from Indian experience.
First, “there is no ideal level of fiscal deficit, and critical factors are: How is it financed and what is it used for?” There is no alternative to SOE efficiency and public investment project financial viability.
Second, “the management of public debt, in countries like India, plays a critical role in development of domestic financial markets and thus on conduct of monetary policy, especially for effective transmission”.
Third, “harmonious implementation of policies may require that one policy is not unduly burdening the other for too long”.
Lessons from China?
Zhou Xiaochuan, then People’s Bank of China (PBoC) Governor, emphasized CBs’ multiple responsibilities – including financial sector development and stability – in transition and developing economies.
China’s CB head noted, “monetary policy will undoubtedly be affected by balance of international payments and capital flows”. Hence, “macro-prudential and financial regulation are sensitive mandates” for CBs.
PBoC objectives – long mandated by the Chinese government – include maintaining price stability, boosting economic growth, promoting employment, and addressing balance of payments problems.
Multiple objectives have required more coordination and joint efforts with other government agencies and regulators. Therefore, “the PBoC … works closely with other government agencies”.
Zhou acknowledged, “striking the right balance between multiple objectives and the effectiveness of monetary policy is tricky”. By maintaining close ties with the government, the PBoC has facilitated needed reforms.
He also emphasized the need for policy flexibility as appropriate. “If the central bank only emphasized keeping inflation low and did not tolerate price changes during price reforms, it could have blocked the overall reform and transition”.
During the pandemic, the PBoC developed “structural monetary” policy tools, targeted to help Covid-hit sectors. Structural tools helped keep inter-bank liquidity ample, and supportive of credit growth.
More importantly, its targeted monetary policy tools were increasingly aligned with the government’s long-term strategic goals. These include supporting desired investments, e.g., in renewable energy, while preventing asset price bubbles and ‘overheating’.
In other words, the PBoC coordinates monetary policy with fiscal and industrial policies to achieve desired stable growth, thus boosting market confidence. As a result, inflation in China has remained subdued.
Consumer price inflation has averaged only 2.3% over the past 20 years, according to The Economist. Unlike global trends, China’s consumer price inflation fell to 2.5% in August, and rose to only 2.8% in September, despite its ‘zero-Covid’ policy and measures such as lockdowns.
Needed reforms
Effective fiscal-monetary policy coordination needs appropriate arrangements. An IMF working paper showed, “neither legal independence of central bank nor a balanced budget clause or a rule-based monetary policy framework … are enough to ensure effective monetary and fiscal policy coordination”.
Appropriate institutional and operational arrangements will depend on country-specific circumstances, e.g., level of development and depth of the financial sector, as noted by both Reddy and Zhou.
When the financial sector is shallow and countries need dynamic structural transformation, setting up independent fiscal and monetary authorities is likely to hinder, not improve stability and sustainable development.
Understanding each other’s objectives and operational procedures is crucial for setting up effective coordination mechanisms – at both policy formulation and implementation levels. Such an approach should better achieve the coordination and complementarity needed to mutually reinforce fiscal and monetary policies.
Coherent macroeconomic policies must support needed structural transformation. Without effective coordination between macroeconomic policies and sectoral strategies, MF may worsen payments imbalances and inflation. Macro-prudential regulations should also avoid adverse MF impacts on exchange rates and capital flows.
Poorly accountable governments often take advantage of real, exaggerated and imagined crises to pursue macroeconomic policies for regime survival, and to benefit cronies and financial supporters.
Undoubtedly, much better governance, transparency and accountability are needed to minimize both immediate and longer-term harm due to ‘leakages’ and abuses associated with increased government borrowing and spending.
Citizens and their political representatives must develop more effective means for ‘disciplining’ policy making and implementation. This is needed to ensure public support to create fiscal space for responsible counter-cyclical and development spending.
Anis Chowdhury is Adjunct Professor of Economics, Western Sydney University & University of New South Wales (Canberra campus). He served as a senior official at UN-DESA (New York) and UN-ESCAP (Bangkok). Prior to joining the United Nations, he was Professor of Economics at Western Sydney University.
Jomo Kwame Sundaram is a prominent Malaysian economist. He is senior adviser at the Khazanah Research Institute, visiting fellow at the Initiative for Policy Dialogue, Columbia University, and adjunct professor at the International Islamic University.
