Today’s article outlines the theoretical construct of central bank credit to governments and the macroeconomic implications. This article referenced largely a study conducted by the International Monetary Fund and it lays the framework for further analysis and contextualisation of the Guyana case which will follow in forthcoming articles. This thematic area is currently being examined by this analyst together with two other prominent Guyanese scholars, one of whom resides locally and the other in the diaspora.
As a key general principle, central banks should refrain from lending to the government, although this may not always be possible depending on the country’s level of development. Governments in industrial countries and emerging market economies should have no access to central bank money because they can raise money to finance fiscal deficits from domestic and international capital markets. In practice, a full prohibition of central bank financing to the government is in place in most industrial countries, most notably in Europe, whereas in emerging markets, a number of countries still allow the central bank to lend to the government, albeit at short-term maturity.
In developing countries, central bank financing to the government may be warranted in the short run. In these countries, government revenues exhibit seasonal fluctuations and capital markets are shallow, thus, making the case for allowing central bank financing in the short run—via overdrafts or through advances—to smooth out seasonal revenue fluctuations. As tax administration improves and money and capital markets deepen, governments should be able to smooth out the seasonality of fiscal revenues.
Central banks may purchase government securities in the secondary market exclusively for monetary policy purposes. Limiting the amounts of these transactions would restrict quantitative easing policies and, hence, this should be done only in extreme circumstances—as the United States and the United Kingdom did in the wake of the recent financial crisis—and under clear and transparent rules. Disclosure of stock and flows of these purchases, vis-à-vis a pre-specified rule or programme, is advisable to allow market participants to monitor that these transactions are made exclusively for the purposes of monetary operations. In countries where the central bank lacks credibility, legislators should consider limiting the number of government securities that the central bank can hold at any one time to avoid any indirect government financing. The limit could be either the number of banknotes in circulation or a proportion of some other central bank liability.
When central bank lending to the government is warranted to smooth out tax revenue fluctuations, and until a fiscal reform smoothens seasonal fluctuations or deeper capital markets compensate for the fluctuations, the operational arrangements in place should follow key principles with the aim of limiting market distortions. These principles are the following: loans should be provided at short-run maturity. Governments should pay back within a short period of time, and certainly before the end of the fiscal year in which the loan is granted. Establishing a more specific term to pay back central bank loans should be determined, identifying seasonal fluctuations of government revenues and how to better smooth them out using short-term central bank money.
The cost of central bank lending to the government should be established by law and be based on market interest rates. Using market criteria is critical in order to reduce government incentives to use central bank money as a source of financing as a first alternative rather than as a last resort. If the interest rate is not a priori defined in legislation, the central bank will generally need to negotiate the rate with the government, which creates an opportunity for government interference in monetary policy implementation.
Central bank loans to the government should have an upper bound. This limit should typically be expressed in terms of a proportion of tax revenues, although other relative measures could also be used, ie, with respect to a central bank liability. This proportion should be set on a case-by-case basis. In practice, most countries limit credit, overdrafts, or advances to 10–20 per cent of government revenues in the previous fiscal year. Establishing limits in terms of government expenditures is not recommended as it tends to be accommodative of expansionary fiscal policy.
The law should protect the central bank against the event that the government does not pay its obligation on time. The central bank should be empowered to debit the government account it holds, or to issue marketable securities on behalf of the government for a value equal to the loan plus interest in arrears. The latter is particularly relevant when it comes to government overdrafts at the central bank. In addition, the government should not be allowed to borrow again from the central bank while it is in arrears. Only the central government should be entitled to borrow from the central bank.
Providing financing to local governments and public enterprises multiplies central bank financing and poses risks of adverse macroeconomic effects. The conditions under which the central bank lends to the government should be disclosed as a good transparency practice. The central bank should establish in the law the conditions governing lending operations to the government, and disclose them on a timely basis, including the amount, interest rate, and maturity of the loans, such that markets can internalise any potential impact on systemic liquidity.
By: JC Bhagwandin, MSc
Email: [email protected]
(The Author is an experienced Macro-finance and Research Analyst; and a Senior Lecturer of BBA / MBA programs at Texila American University, University of Bedfordshire and the Association of Business Executives (ABE) programs in Guyana. The discussions and analyses presented are exclusively his own and do not necessarily reflect the opinions of this newspaper nor the institutions he is affiliated with.)