Central Bank Independence and Implementation of Monetary Policy

It is to certify that this report submitted by Mr. Raza Ali and Mr. Farhan Ahmed is accepted in its present form by the Monetary Policy Department, State bank of Pakistan Karachi, as satisfying for the requirement for partial fulfillments of the Internship Program. Supervisor Javed Iqbal Central Bank’s Independence and Implementation of Monetary Policy Page 2 Internship Report Acknowledgement We would like to thank Mr. Javed Iqbal (Monetary Policy Department) for his support and guidance during the preparation of this report.

We would also like to extend our gratitude to the other staff members of the Monetary Policy Department who have remained supportive during our internship. We would like to thank the State Bank of Pakistan for providing us with this valuable opportunity and resources to conduct our research. Central Bank’s Independence and Implementation of Monetary Policy Page 3 Internship Report Abstract Economic indicators like Inflation, GDP growth, Borrowing from Central bank, Monetary Policy and CBI, Nominal and Real interest rates, Wage rates and Output sacrifice ratio have been analyzed to explore the effectiveness of Monetary Policy in Pakistan.

Analysis of various economic indicators show that performance on these indicators could have been better had our monetary authorities had more autonomy. Central Bank’s Independence and Implementation of Monetary Policy Page 4 Internship Report Table of Contents Introduction………………………………………………………………………………………………………………Page06 Literature Review………………………………………………………………………………………………………Page7-9 Defining Central Bank Independence (CBI)……………………………………………………………….. Page10 Measuring Central Bank Independence (CBI)…….... ………………………………………………. Page11- 12 CBI & Economic Performance………. ……………………………………………………………………….

Page13-16 Conclusion…………………………………………………………………………………………………………………Page17 References…………………………………………………………………………………………………………………Page18 Central Bank’s Independence and Implementation of Monetary Policy Page 5 Internship Report 1. Introduction The Central bank of any country plays a vital role in the economy of that country. It plays a major role by being Government’s bank and helps Government in smooth running of economic affairs by maintaining the price stability in the system. Historically, the role of the Central bank was to print money, hold foreign reserves, formulate monetary policy and act as Lender of Last Resort (LOLR).

The beginning of the 1990’s marked the new era in the history of central banks’ roles, when Reserve Bank of New Zealand was granted the clear objective of maintaining the price level stability in the economy with operational independence to achieve this objective. Soon Bank of Australia, England and Canada were granted the same autonomy. But this only objective was confined with central banks of developed countries, whereas central banks in developing countries are performing another role and that is to support growth in the economy. Developing nations’ central banks have since then have shifted their focus in order to achieve these goals.

Historical data of Inflation and GDP growth of developing nations suggest that these both goals have not been achieved, if achieved then their sustainability remains short. This may be due to some missing factors like Central Bank’ Independence and autonomy whether in goal setting or in ways through which it achieves its goals. Thus the objective of the study is to find out whether SBP, in its completion of goals is independent or not? And is there any relationship between CBI, macroeconomic variables and effective implementation of monetary policy.

Section 1 covers literature review, section 2 of this paper covers definition of CBI, section 3 of the paper explains how CBI is measured; section 4 shows relationship between CBI and economic performance and section 5 concludes the report’s main points. Central Bank’s Independence and Implementation of Monetary Policy Page 6 Internship Report 2. Literature review Cukierman, Alex, (2005) in his paper Central Bank Independence and Policy Results: Theory and Evidence has put great emphasis on the high level of Central Bank Independence (CBI) and argues that it is the desirable feature of any monetary policy making institute.

He states that the most important responsibility of the Central Bank (CB) is to assure price and financial stability and to achieve its main objective the bank should have (a) Instrument independence, (b) bank should not lend to government, (c) bank should have sufficient financial independence and (d) bank’s high officials shall hold posts for longer tenures and they should not work anywhere else in order to avoid conflict of interest. Author further goes on to explain existing relationship between CBI and economic performance in the areas of Inflation, growth, investment and real rates in his paper.

Walsh E. Carl, (2005) in Central bank independence prepared for the New Palgrave Dictionary defines CBI as “the freedom of monetary policymakers from direct political or governmental influence in the conduct of policy”. Carl in the later part of the paper states that many developed countries after 1980’s have granted greater independence to their monetary authorities and these reforms have shown negative correlation between CBI and stable and low inflation rate. In the case of developing countries, he says that there exist positive relationship between CB Governors’ turnover rate and inflation.

Paper highlights that critics of the reform movements towards central bank independence have expressed concerns that independence can weaken the accountability of central banks and they should be supervised in their goal setting and implementation process. Alpanda et al. , (2009) in Political monetary cycles and a de facto ranking of central bank independence state that political monetary cycles are less likely to occur, in countries with independent central banks. CB, if independent can resist political pressure exerted to stimulate the economy before elections in the form of increased government spending or tax cuts.

Writers further argue that money growth is larger among countries having low CBI in election periods vs. non election periods. Two variables were used to identify occurrence of political monetary cycles i-e M1 and election dates of the national leaders. Alpanda et al. , have ignored the borrowing capacity of government as high capacity of borrowing would Central Bank’s Independence and Implementation of Monetary Policy Page 7 Internship Report lead to lesser need for distortion in monetary policy.

Rankings are therefore derived from the behavior of central banks during election cycles when their independence is likely to be challenged or their lack of independence is likely to be revealed. Siklos L. Pierre, (2008) in “Does central bank’s independence still matters? ” says that the term “independence” defines the position a monetary authority has in the state of affairs. Author states that CBI has been loosely defined to meet the needs of countries such as turnover rate (TOR) and on other side it has been defined as set of characteristics that are legally defined and show relationship between government and CB.

Author argues that CBI is not measured as a single index but is set of dejure and defacto characteristics and of those the optimal level cannot be found. Four elements of each characteristic are selected to convey negative relationship between CBI and inflation. Jeroen et al. , (2009) in their paper “Inflation and central bank independence: A metaregression analysis” elaborate that many countries granted their monetary authorities greater independence.

According to authors, to identify whether there is any relationship between CBI and inflation, one needs an indicator of the extent to which the monetary authorities are independent from politicians. Most empirical studies use either an indicator based on central banks’ laws in place or TOR. Authors suggest that countries with a more independent central bank will, on average, have lower levels of inflation. Billin, (2001) in “Central bank independence and economic performance in Eastern Europe” writes that both the measures of CBI and of financial market development (FMD) show significant association with macroeconomic variables.

Next section of his paper examines both the trends and the economic performance in eight Eastern European countries and the degree of CBI granted after reforms. The author argues that both CBI and FMD may facilitate market reforms by helping to enforce fiscal and financial discipline. Author’s empirical inquiry via correlation analysis suggests positive association of both CBI and FMD with price stability. Jose De Gregorio in his presentation on Central Bank Independence and the Effects of Monetary Policy (2005) says that legal CBI is negatively correlated with inflation in Eastern European and Latin American countries.

Furthermore, he goes on to say that legal Central Bank’s Independence and Implementation of Monetary Policy Page 8 Internship Report independence is precondition to gain credibility in countries where inflation records are poor for independent functioning of the CB. He concludes on the point that narrow pass through of exchange rate to import prices and macro economic performance is positively linked to CBI. Jacome et al. , in their paper “Any Link Between Legal Central Bank Independence and Inflation” Evidence from Latin America and the Caribbean” (2005) have tried to find out negative relationship between legal CBI and inflation.

They have used different measures of legal CBI like the rules for the appointment of central banks’ board of directors, the degree of CBI in the conduct of exchange rate policy, rules governing Lender-of-Last-Resort (LOLR) facilities and legal requirements on accountability and transparency and the results show negative relationship between legal CBI and inflation after controlling for international inflation, banking crises, and exchange regimes in the sampled countries. Central Bank’s Independence and Implementation of Monetary Policy Page 9 Internship Report 3.

Defining Central Bank Independence Defining the concept of Central Bank’s Independence (CBI) is a tricky job. It seems to be an unambiguously defined concept now, because we as authors end up defining our own understanding of it. Large amount of work has been done to argue that high CBI is directly related to the long term economic performance. The primitive work on the definition of CBI was done in 1824 by David Ricardo who emphasized on issuance of the currency by Commission elected by government and communication hindrances between them on the issue of lending currency to the state.

The advocates of the high CBI throughout the world are found to be on the common grounds i-e they all agree to it that if central bank is not independent politicians can abuse the power of printing money and this is how they can distort the inflation and output level in the economy in order to earn political gains, whereas central bank is seen as playing role in the best interest of the society. It is also considered that there may be no single and right definition of CBI, but in general it is defined within two factors/aspects of the independence; Independence of objectives and Independence of instruments.

Independence of objectives refers to the autonomy central bank has in setting its own goals whether that can be of inflation targets, money supply, exchange rate management or others. Independence of instruments refers to how much central bank has independence in determining the best possible ways to achieve its policy goals. This bifurcation is widely accepted by Fraser (1994), Briault et al. , (1996), Amtenbrink et al. , (1998) and Debelle (1995). Siklos, (2008) argues that the definition of CBI has not been defined narrowly. Some measure it in the turnover rate of governors (see Dreher et al.(2007)) while others state that it the existing set of characteristics that defines relationship between the government and the central bank.

The bottom line is that economists are still trying to precisely define CBI and its significance for achievement of the required targets set by government or central bank. Central Bank’s Independence and Implementation of Monetary Policy Page 10 Internship Report 3. 1 Measuring CBI In order to gauge the independence of CB, following criteria have been selected: ? Appointment of the CB Governor: As per literature review, appointment of the governor comes under legal independence of CB.

Pakistan does not perform well in this area as the governor is appointed by federal government and the tenure of the office of the governor is three years compared to five year’s tenure of governors in other South Asian countries like Japan. If we see the TOR of SBP governors from 1999 to 2011, it stands at 0. 33. This high TOR may suggest that the occupants of the posts were not happy with the working environment and the autonomy under which they operated, but lower TOR may also not suggest that the CBI is higher, as occupant of the post may be subservient to government so that he/she can hold the post for longer tenure.

? Setting of Monetary policy targets: Key targets of inflation and growth rate are set by fiscal authorities whereas SBP only adjusts its monetary policy to try and achieve those goals. Thus we can say that central bank does not enjoy goal independence but a degree of instrument independence. Even if we analyze the instrument independence aspect of SBP, it may have to change the ways to achieve the objectives through monetary policy as the Central Board is mainly comprised by those who are appointed by federal government.

? SBP’s saying in the government financing of fiscal deficit: As per SBP (Amendment) Act 2012, Federal Government borrowing from SBP shall be brought down to zero and the limit of borrowing shall be determined by the Central Bank from time to time but we don’t see federal government obliging to the act. SBP on other hand has been continuously showing its concerns over this issue as it can be clearly observed in their MPS that says: “The impact of SBP’s monetary policy is less effective. The economy basically needs fundamental reforms to engineer a turnaround in economic performance.

For instance, inflation expectations cannot be effectively anchored around single digit targets without limiting accelerated fiscal borrowings from the banking system, particularly the SBP and monetary policy in these circumstances has been less Central Bank’s Independence and Implementation of Monetary Policy Page 11 Internship Report effective” 8th June, 2012. Thus we may say that SBP does not enjoy more autonomy in restricting the government to borrow and retire its debt obligations.

? Disclosure in policy changes, accountability and transparency: SBP has made itself accountable to its stakeholders by regularly publishing any changes that take place. This has led to increase in transparency and will help gain more credibility in the eyes of its stakeholders. The SBP Act 1956 defines the objectives of SBP as: “The Monetary Policy Committee shall without any prejudice support the economic policies of Government. It shall formulate, decide and implement monetary policy; decisions related to key interest rates and determine the limit and nature of loans and advances to be extended to Government”.

Based on these objectives, some economic indicators have been selected to analyze SBP’s performance and the autonomy it has, in order to carry out its objectives. 3. 2 CBI and Economic Performance Following economic indicators have been selected to find out their relationship with central bank’s independence. 3. 2. 1 Inflation Figure 1 shows difference between the target and achieved inflation rate. From FY 99 till FY 04, SBP has successfully achieved targets set for inflation and we can say that the monetary policy has been effective during this period.

But if we analyze the period from FY 05 to FY 11, inflation targets have not been achieved. To find out why these targets have not been met, we calculated correlation b/w inflation and Government borrowing by taking data from FY00 to FY11 that stood at 0. 81. Thus major reasons for not achieving the targets can be attributed to high Government borrowings. Furthermore, supply side shocks like devastating floods, strong global prices of oil and Figure 1: Difference b/w target & actual CPI 7. 0 6. 0 5. 0 4. 0 3. 0 2. 0 1. 0 0. 0 -1. 0 -2. 0 -3. 0 FY04 FY99 FY00 FY01 FY02 FY03 FY05 FY06 FY07 FY08

FY09 FY10 Central Bank’s Independence and Implementation of Monetary Policy Page 12 FY11 Internship Report agriculture commodities have also played their role during this period. Our own internal factors accompanied by external factors made monetary policy ineffective and as a result targets were not achieved. 3. 2. 2 GDP A monetary policy is said to be effective, if it achieves low and stable inflation rate and supports growth in the economy. In our case, we can say that monetary policy remained effective from FY 99 till FY 04 as inflation was low and GDP growth rate was high (see Figure 2) .

But from FY 06 to FY 12, inflation has been on the rise and GDP growth rate has declined over the period as shown in Figure 3. Several factors have led to this high inflation and low GDP growth rate period. Our trade deficit in ($ billion) rose from 11 to 17, current account as percentage of GDP rose from 4. 6 to 6. 9, fiscal deficit as GDP percent increased from 4 to 6. 5, political motives were given more precedence than economic problems examples of which could be seen in Government’s reluctance in passing oil price shock to consumers as subsidies in oil price of Rs. 175 billion at $115/barrel in May’08 and Rs.

113 billion in electricity tariffs were given to end consumers and as a result we are now facing problem of circular debt that is hurting our growth rate. Immense hike in international food prices was also witnessed that led to Inflation (MoM as of Oct’08) of 25% besides that major role was being played in war against terror leading to deteriorating law & order in the country. All these economic factors led to Balance of Payment crisis in the country and we had no choice left but to go to IMF to seek help. Under agreed SBA terms and conditions with IMF, we had to reduce fiscal deficit target from 7. 6% in FY09 to 4.

3% in FY10 and to 3. 3% in FY11 and this was tried to be achieved through cut in Public Sector Central Bank’s Independence and Implementation of Monetary Policy Page 13 18. 0 16. 0 14. 0 12. 0 10. 0 8. 0 6. 0 4. 0 2. 0 0. 0 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 Figure 2: GDP Growth Rate 10. 0 9. 0 8. 0 7. 0 6. 0 5. 0 4. 0 3. 0 2. 0 1. 0 0. 0 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 Figure 3: Trends in CPI and GDP CPI GDP Internship Report Development Program (PSDP) from budgeted amount of Rs. 452 billion in FY08 to Rs. 365 billion in FY09, whereas, in actual it was Rs.

246. 3 billion in FY09. Other major conditions under SBA like increase in discount rate by 200 bps from 13% to 15% in Nov’08 to curtail inflation and rise in indirect taxes on consumption affected the growth and purchasing power of all the poor class segments of the society. Other supply side shocks after 2010 like floods and hike in electricity tariffs, accompanied by excessive borrowing from Government at average rate of 120% from FY07 to FY11 had fueled the inflation and all this if concluded has left long term implications on inflation curtailment as it has remained in double digit figure and growth.

3. 2. 3 Borrowing from domestic sources, Monetary Policy & CBI Analysis of figure 4 suggests positive correlation between government 800000 600000 400000 200000 0 -200000 -400000 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 Figure 5: Trends in Budgetary Borrowings and NDA Budgetary Borrowings 700 600 500 400 300 200 100 0 -100 -200 NDA 8000 7000 6000 5000 4000 3000 2000 1000 0 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 Figure 4: Govt: borrowing and CPI Borrowing from SBP CPI Inflation 18. 0 16. 0 14. 0 12. 0 10. 0 8. 0 6.

0 4. 0 2. 0 0. 0 borrowing from SBP and CPI i-e (0. 5 if we calculate by taking data of CPI and borrowing from SBP from FY99 to FY 12). High government borrowing from domestic sources as shown in Figure 5 below owing to reasons like insufficient foreign inflows due, mounting fiscal deficit, losses of Public Sector Enterprises and huge rupee subsidies on commodities has not only kept pressure on CPI but has also led to crowding out effect for the private sector. It is also expected that government’s need to borrow from domestic sources will be high as financing target of Rs.

1105bn in FY13 has been set and SBP’s push for a net-zero financing from it can be viewed as overly optimistic to believe by looking at Rs. 564bn standing in government account. Central Bank’s Independence and Implementation of Monetary Policy Page 14 Internship Report Thus further violation of SBP (Amendment) Act 2012 will be seen in FY 13. Violation of CB autonomy has not only made monetary policy ineffective in terms of achieving inflation targets but this has also reduced the chances of policy rate cut and improvement in crowding out effect that can trigger growth in the economy. 3. 2.

4 Nominal and Real interest rates and Wage rates Behavior of the nominal and real interest rates has close link with central bank’s credibility and autonomy. If the central bank is credible, any expectation to bring the inflation level down will follow a change for a certain period of time in the nominal and real interest rates even if inflation level stays the same and there is no cut in the policy rate. Example of this can be witnessed in the 25th July, 2012’s T-bills auction where we saw a decline of up to 5 basis points in the T-bills rates due to expectation that inflation is going to ease and there are chances of a possible rate cut.

Similar instance can be observed in the trading of 10 year PIB bond where it was traded to as low as 13% in the secondary market due to the similar expectations. Such expectations also lead to a minimal increase in the workers’ wage rates in the economy as firms expect that the central bank will take measures to bring the inflation level down and thereby decreasing the firms’ expenses. 3. 2. 5 Output sacrifice ratio A better measure to gauge the Central bank’s independence and credibility is output sacrifice ratio that is the cost of bringing the inflation level down in the economy.

In our case, we have been unable to bring the inflation level down to single digit and achieve sustainable growth rate in the economy there by missing both the key monetary policy targets form FY 07 to FY 12 as shown in Figure 6. CB if more credible and independent can bring the inflation level down at a lower opportunity cost and we will be able to see better economic performance by monetary policymakers. Central Bank’s Independence and Implementation of Monetary Policy Page 15 Figure 6: Trends in Inflation and GDP Growth Inflation 18. 0 16. 0 14.

0 12. 0 10. 0 8. 0 6. 0 4. 0 2. 0 0. 0 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY 12 GDP growth 10. 0 8. 0 6. 0 4. 0 2. 0 0. 0 Internship Report 4. Conclusion This study aims to investigate relationship between central bank’s independence and effective implementation of monetary policy. In the literature, CBI is defined as having the authority to set goals and complete independence in deciding how to achieve those goals. Some of the authors have defined CBI through factors like appointment and tenure of Governor and others.

The empirical researches that were conducted in Latin America and Eastern Europe and at other places covered in different authors’ work prove that there exist negative correlation between CBI and inflation and suggest that political monetary cycles do not exist where central banks are more independent. In order to measure SBP’ s independence, indicators like, appointment of the SBP Governor, setting of Monetary Policy targets, SBP’s say in the government financing of fiscal deficit, disclosure in policy changes, accountability and transparency have been employed.

Furthermore, economic indicators like Inflation, GDP growth, borrowing from central bank, Monetary Policy & CBI, Nominal and Real interest rates, Wage rates and Output sacrifice ratio have been analyzed to explore the effectiveness of monetary policy in Pakistan. Analysis of mentioned economic indicators show that performance on these indicators could have been better (such as high government borrowing has put inflationary pressures and due to this inflation targets have been missed) had our monetary authorities had more autonomy.

Central Bank’s Independence and Implementation of Monetary Policy Page 16 Internship Report 5. Reference Alex Cukierman, (2005),” Central Bank Independence and Policy Results: Theory and Evidence” Walsh E. Carl, (2005), “Central bank independence prepared for the New Palgrave Dictionary” Alpanda et al. , (2009), “Political monetary cycles and a de facto ranking of central bank independence” Siklos L. Pierre, (2008), “Does central bank’s independence still matters?

” Jeroen et al. , (2009), “Inflation and central bank independence: A meta-regression analysis” Billin, (2001), “Central bank independence and economic performance in eastern Europe” Jose De Gregorio, (2005), “Central Bank Independence and the Effects of Monetary Policy” Jacome et al. , (2005), “Any Link between Legal Central Bank Independence and Inflation” Evidence from Latin America and the Caribbean” Central Bank’s Independence and Implementation of Monetary Policy Page 17.