Opinion

Monetary financing needs careful consideration


Published : 06 Dec 2022 07:23 PM

Economists have been carefully monitoring the evolving eroding global financial scenario and also what is happening within Bangladesh.  Civil society groups have been analyzing the developing socio-economic situation in South Asia and providing helpful suggestions as to how our Bangladesh Bank and other financial institutions might be able to interact with each other through the required least common denominators.

Some are suggesting that monetary financing is a process that needs to be followed very carefully- particularly if it involves borrowing from central banks (CBs) to finance government spending. Analyst A. Chowdhury and J.K. Sundaram has even pointed out that some countries have already even legislated against CB financing of fiscal expenditure.

Apparently such laws are supposedly needed according to these economists “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.” 

However, such action has been described as countries “tying their own hands with restrictive legislation”. Some others on the other hand have “pragmatically suspended or otherwise circumvented such self-imposed prohibitions” to enable them to “borrow from CBs to finance pandemic relief and recovery packages”.

Such action as expected appears to have opened the door to differences of opinion over the urgent need for counter-cyclical and developmental fiscal-monetary policy coordination. Social strategists have been following this differences of opinion- particularly because some financial institutions have claimed that such a process enables national CBs to finance government deficits, i.e., monetary financing (MF). On the other hand other strategists have suggested that MF does not always work in a positive manner pertaining to public debt, balance of payments deficits, and runaway inflation. In this context some economists have recalled the views expressed by W. Easterly who commented that “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”. Consequently, this dimension has led to calls for MF being met with “scepticism, if not outright opposition”.  A. Chowdhury and J.K. Sundaram has also expressed the view that MF could undermine central bank independence (CBI) and also affect possible strict segregation of monetary from fiscal authorities. This in turn could derail efforts to prevent runaway inflation.

Within this matrix and paradigm many economists and also senior officials associated with banking have also suggested some significant potential measures.

Former Reserve Bank of India Governor Reddy has noted that 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. A. Chowdhury and J.K. Sundaram have remarked that for Reddy, “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”.

It would only be pertinent to also remember that monetary policy is constrained at times by large and persistent fiscal deficits. This might vary from country to country. However, for Reddy, “undoubtedly the nature of interaction between -fiscal and monetary policies- depends on country-specific situation”. Consequently, Reddy has urged addressing monetary-fiscal policy coordination issues within a broad common macroeconomic framework.

Several lessons can be drawn from the recent Indian experiences. As there is no identified perfect level of fiscal deficit, the following factors assume critical importance in India- how is it financed and what is it used for? In order to monitor such a scenario particular emphasis will have to be given to efficiency within state owned enterprises and also with regard to financial viability within public investment projects. 

Reddy also correctly emphasized that “the management of public debt, in countries like India, plays a critical role in development of domestic financial markets and thus in the conduct of monetary policy, especially for effective transmission”.

Interestingly Z. Xiao Chuan associated with the People’s Bank of China (PBoC) has also underlined the critical multiple responsibilities of Central Banks – including financial sector development and stability–within developing economies undergoing transition. According to him this function is required as “monetary policy will undoubtedly be affected by balance of international payments and capital flows”. Hence, “macro-prudential and financial regulations are sensitive mandates for Central Banks”. Consequently, PBoC objectives – long mandated by the Chinese government – include maintaining price stability, boosting economic growth, promoting employment, and addressing balance of payments problems. Such multiple objectives have also required more coordination and joint efforts with other government agencies and regulators. Zhou has also asserted the need for “striking the right balance between multiple objectives and the effectiveness of monetary policy- which is tricky”. He has also asserted that during these troubled times the Central Bank not only needs to maintain close ties with the government for facilitating needed reforms but also do so with a degree of appropriate policy flexibility.

Attention needs to be drawn to some interesting facts about how the Chinese government and their PBoC have been functioning during the pandemic and how monetary policy tools were used to target in their effort to help Covid-hit sectors. Structural tools helped keep inter-bank liquidity sufficient, and supportive of credit growth. This function was carefully associated with the Chinese government’s long-term strategic goals. This included supporting desired investments in renewable energy and also preventing unnecessary overheating in asset prices. This, according to Zhou, was done to coordinate and interactively engage monetary policy with fiscal and industrial policies to achieve desired stable growth, and boost market confidence. This has resulted in inflation remaining reasonably under control in China. It may be mentioned here that foreign media including ‘The Economist has noted that consumer price inflation has averaged only 2.3% over the past 20 years in China. 

We have seen how in recent days inflation hawks have had no hesitation prescribing their standard inflation counter – raising interest rates. However they seem to forget that raising interest rates may help if inflation is mainly due to easier credit fuelling demand. On the other hand tighter credit is unlikely to effectively address ‘supply-side’ inflation, which typically requires targeted measures to overcome bottlenecks.

The adverse spill-over impacts of rising interest rates are also considerable. Raising rates in major advanced economies appear to have weakened emerging market and developing economies (EMDE) capital inflows, currencies, fiscal positions and financial stability, especially as sovereign debt has ballooned over the last two years.

Higher interest rates also tend to increase borrowing costs, squeezing investment and household spending. This hits businesses, hurting not only employment opportunities but also incomes and can result in a vicious downward spiral. It also increases governments’ debt burdens, forcing them to cut spending on public services including healthcare and education. Accordingly, it is difficult to understand either how elevated interest rates will not harm investments, jobs, earnings and social protection or curb food or oil price increases. One might be correctly thinking that essential consumer prices will rise, even with high interest rates.

Higher interest rates may even aggravate inflation as businesses cut investment spending. Thus, supply bottlenecks, especially of essential goods, are likely to be more severe, pushing up their prices.

We need to remember that in a developing country most people are indebted, with the poor often borrowing to smoothen consumption. Thus, the poor are hurt in many ways: losing jobs and earnings, coping with less social protection, and having to borrow at higher interest rates. Hence, we need to recognize that the standard medicine of higher interest rates can have massive social costs. Meanwhile, the principal beneficiaries of using higher interest rates to lower inflation become rich net creditors and financial asset owners.

Consequently, effective fiscal-monetary policy coordination needs appropriate arrangements to ensure effective monetary and fiscal policy coordination. Appropriate institutional and operational arrangements will also have to depend on country-specific circumstances- level of development and depth of the financial sector.

Undoubtedly, one also needs to remember that the whole effort will need much better governance, transparency and accountability. This can help in minimizing both immediate and longer-term harm due to abuses associated with increased government borrowing and spending. Citizens and their political representatives must also 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.


Muhammad Zamir, a former Ambassador, is an analyst specialized in foreign affairs, right to information and good governance