Noor Israr describes a crucial monetary institution
Since the last few years, the Position of Central Bank of Pakistan known as the State Bank of Pakistan (SBP) has grown in stature though most of the limelight on the institution is consistently mixed leaving people to draw their own conclusions. Though SBP is now an entity that is to be reckoned with but apparently the independence of action it has been granted is full of controversies that may require some time to be appropriately resolved. Many observers foresee a turbulent future for the relations between governmental financial mechanism and the relative independence of SBP simply because a monetarily stricken country like Pakistan can ill-afford a perpetual hardline aloofness of the central bank. It is from this perspective that this institution is required to be looked at.
It is well-known that modern central banks are public, nonprofit, eco¬nomic and political institutions deriving their clout from their command over mon¬etary resources. Their ambit of responsibility includes shaping monetary policy, exerting strong influence on exchange rates and act as guardians of financial stability. Their decisions influence economic variables determining growth, output and national development policies and have a bearing on the conditions of international financial and monetary cooperation. Central banks however are regulated by a mandate from respective governments specifying their goals and the conditions under which control over monetary resources is exercised. Yet in the current globalised financial scenario the trend is toward cen¬tral bank independence from elected governments that often creates issues.
The predominant influence of central banks is felt in terms of goals that converge toward the primacy of price stability and the mandated use of monetary resources in an atmosphere of statutory independence. Actually a central bank’s status as a public, nonprofit institution is the outcome of an evolutionary pro¬cess, based on the rules and social institutions that underpin its three core functions that are its position to act as banker to the government, its monopoly of note issuance and as banker to the banking system includ¬ing that of last-resort lender. These functions refer to the unique relationships between the institution and its principal clients: the government and the profit-maximizing financial institutions, mainly commercial banks.
As a public national institution, the central bank derives its functions from a state-backed power as the sole issuer of a unique currency circulating in a geographical territory to which it has been granted the status of legal tender. Parallel to the processes of political delegation, a contractual, economic relationship with the gov¬ernment involves mutual economic interest and economic calculation. Lending to the government, at an agreed fixed interest rate, generates profits alongside those drawn from currency issuance. For the government, having its own bank ensures cheaper deficit financing; its power as principal borrower is used to press for a minimum rate of interest. On the other hand, central banks typically stand out as major holders of a government’s debt, insofar as they invest their capital in government long-term debt instruments, mainly bonds. Where a domestic public debt market exists or is being established, voluntary loans from private savers provide an additional source of deficit financing. It is a market monitored by the central banks adding the function of debt management to their other functions.
While the government’s preference for cheap finance is an intrinsic component of its relation¬ship to their central banks, deficit financing through monetary expansion proved exceptional in industrialised countries. Economic as well as political reasons for central banks compel them to be congenitally inflation and risk averse. Because they are major holders of the gov¬ernment’s debt and because they already profit from lending to the government, they have an overriding interest in keeping the real value of its loans stable. There is also a reputation dimen¬sion to its practice, in that the strength of the currency issued is closely related to the credit¬worthiness of the issuer and to the commitment of the issuing institution to price stability. The inflationary bias of economic policy and the temptations of monetary financing of govern¬ment spending in countries are late developments that call for a more contextualised analysis of the unstable monetary regime in the financial globalisation era.
Central banks as bankers to the banking system, play a leading role mainly vis-à-vis commercial banks and less effectively vis-à-vis other profit-maximising financial institutions. Such a role primarily is one of guidance and monitoring because commercial banks act simultaneously as deposit takers and loan makers, therefore they are credit multipliers. Since credit is money, their individual microeconomic decisions, guided by profit-maximising considerations, have a direct bearing on the increase or reduction in the stock of money available in the economy. Central banks’ overriding concern with financial and economic stability gradually evolved toward a proactive role in averting this source of volatility. Their function as lender of last resort to the banking system revolves around the bank’s systemic responsibility, in exchange for enhanced powers of supervision and regulation of commercial banks’ behaviour.
In order, to maintain day-to-day control over the short-term nominal inter¬ests rates in all market conditions, the central bank purchases or sells financial securities for cash to change the monetary base. Its power to influence the money supply and other economic variables in this case is exercised through the markets. Because the central bank can impose the ultimate condi¬tions for granting credit, it enjoys the powers of creating or restricting money but it does so by relying on market mechanisms such as its monopolistic position in the credit market and on the predictably self-interested response of profit-maximising institutions to its interest rate policy.
It is in this context that the use of the term central bank is equivalent to and interchangeable with that of monetary authority. This identity relies on three assumptions and they are that wher¬ever a market exists, financial firms and investors act independently from one another. Secondly, the central banks’ power over monetary resources is that of a rule maker implying an extension of the state’s capacity of enforcement. Moreover, its creditworthi¬ness derives from its governance capacity in terms of price and financial stability, which in turn derives mainly from its technical credentials. Central banks’ current powers are tied to criti¬cal shifts in their relationship with their constituen¬cies and in the cognitive maps adopted by central bankers. A salient aspect of those developments is a shift in the priorities of monetary management toward the primacy of price stability over other policy goals, such as the promotion of full employ¬ment and maximum output.
In the fast evolving monetary climate the powers of national central banks are consistently redefined and that is precisely what is happening in Pakistan. Insofar as the evolution of SBP involved a long-term project is concerned, multiple acts of sovereign political delega¬tion are required to be undertaken for establishing a transnational monetary authority through state¬craft in connection with developing countries. It is within this shifting monetary, financial, and political context that the new powers and func¬tions assigned to central banks vis-à-vis the gov¬ernments become meaningful. The centrality of the monetary policy and the monetary counter-reaction to the dominance of free economic system has marked out a paradigmatic shift away from the situation prevalent just few decades before as the current emphasis is structured around demand management and based on exchange rate, price and interest rate controls and these are the pressing reasons calling for an end the subordination of central banks to governmental financial requirements and bodies. TW
Noor Israr has a discerning taste in music and is currently studying development economics at UCF