Escolar Documentos
Profissional Documentos
Cultura Documentos
30, 2015
A central bank can earn its living by printing money
A central bank is a unique species. It does not have to work in order to earn
its existence. This is because it has been given a power which no one else
in society has. That power is to have all the resources it wants just by
assuming a liability through a mere book entry.
For instance, suppose it wants to lend to the government by buying a
Treasury bill. All it has to do is to debit a Treasury bill holding account in its
books and debit that account and credit the value it has lent to the
government to the governments deposit account which it maintains in its
books.
Then, how does the government make use of the money lent to it by the
central bank? It can do so by resorting to one of the two methods available
to it. One is that it can write a cheque on its account with the central bank
and make payments to somebody in the economy. The recipient of the
cheque will collect cash from his bank which will collect it in turn from the
central bank. Or else, the government can withdraw cash directly from the
central bank and make payments to somebody in the economy. In either
case, the central bank meets its liability by issuing currency which it can
print at its pleasure.
To print a currency note, the central bank does not have to incur a cost
equivalent to the face value of a given currency note. This is because
currency notes today are printed on paper and not made of precious metals
like gold or silver. Hence, to issue a 5,000 rupee note, the central bank
incurs a cost of, say, about 10 rupees. This is a highly profitable business
because it earns a profit of 4990 rupees for the central bank. Such profits
are known in economics as seigniorage.
Monetary
board
headed by governor should live up to the trust placed by public in them
Hence, those who run central banks may be tempted to earn the maximum
seigniorage for them as well as for the political masters who have
appointed them. But excessive seigniorage means excessive printing of
money and excessive printing of money means excessive inflation in the
economy. The real harm which this process would do to an economy was
discussed in a previous paper in this series titled Is a little bit of inflation
necessary for economic growth? (available at:
http://www.ft.lk/2014/02/10/is-a-little-bit-of-inflation-necessary-foreconomic-growth/).
The article has argued that such a policy is a lose-lose policy since both
the government and the members of the public stand to lose at the end.
The biggest loss to the public is the loss of wealth which they have kept in
money form trusting the central bank. Society has placed the
responsibility for preserving that trust in a group of people called the
Monetary Board headed by the Governor of the Central Bank.
Governor and Monetary Board are trustees and not owners
Thus, the governor and the members of the monetary board are simply
trustees and not the owners of a central bank. A trustee has a legal
meaning as well as an economic meaning. The legal meaning is that a
trustee has to take the same care and caution when he handles the assets
This was explained in a previous article in this series titled Even mighty
central banks can go broke if imprudent policies are adopted (available at:
http://www.ft.lk/2013/12/02/even-mighty-central-banks-can-go-broke-ifimprudent-policies-are-adopted/). It was pointed out that a central bank
should not get into speculation of currencies and exchange rates or into
heavy foreign borrowings since the outcome would be an incurrence of
embarrassing losses for the countrys taxpayers.
Three widely-publicised cases were discussed in the article. The first related
to Bank Negara Malaysia speculating on the British pound in early 1990s
and losing an estimated $ 5.5 billion. The second was how the Bank of
Thailand sought to protect Thai Baht insanely in 1990s and lost $ 25 billion
in the process. The third involved the Central Bank of the Philippines
borrowing heavily to finance governments loss making capital projects and
becoming bankrupt in 1993.
In all these cases, the losses were borne by taxpayers and therefore the
governing boards of the respective central banks had failed to discharge
their trustee obligations properly. Hence, proper risk management in a
central bank is a must and the Governor and the board members should
establish proper risk management mechanisms in them.
Good governance in central banks is important on three grounds. First, society looks
up to central banks as model institutions to emulate. If they do not have good
governance practices, then, the place of the central bank in society is grossly
undermined. Second, central banks insist that all banks and financial institutions that
are being supervised and regulated by them should have good governance practices. If
the regulator does not have good governance practices, then, it cannot impose its will
on banks. Third, good governance improves the internal management of a central bank
and establishes a proper accountability mechanism in it
Both the governor and Monetary Board members should possess a clear and high
knowledge of economics, banking, finance, etc. They should have a very wide global
outlook. They must be aware of the emerging global conditions and make suitable
changes to the domestic monetary and financial policies to mitigate the risks involved.
Above all, as Exter had highlighted, they should be people of unquestioned integrity
and responsibility. What this means is that if anyones integrity has come to be
questioned, he does not fit to hold the high post of governor of the Central Bank or
become a member of its Monetary Board. The same requirement holds equally for the
senior career officers of the Central Bank too
Good governance a must for a central bank
Good governance in central banks is important on three grounds. First,
society looks up to central banks as model institutions to emulate. If they
do not have good governance practices, then, the place of the central bank
in society is grossly undermined. Second, central banks insist that all banks
and financial institutions that are being supervised and regulated by them
should have good governance practices. If the regulator does not have
good governance practices, then, it cannot impose its will on banks. Third,
good governance improves the internal management of a central bank and
establishes a proper accountability mechanism in it.
These issues were discussed in detail in the article titled Governance of
central bank boards published in this series (available at:
http://www.ft.lk/2013/08/19/principles-of-central-banking-2-governance-ofcentral-bank-boards/). As the article has argued, governance principles that
stipulate clearly the relationship which the monetary board has with its
stakeholders help it earn market confidence, establish financial integrity
and promote economic efficiency.
Governance components in a central bank
central banks have been made board members, but they are always being
outnumbered by the non-executive members appointed from outside.
Deputy governors should also be people with knowledge, experience and
maturity
Hence, in banks where the majority rule constitutes the decision making
criterion, the appointment of deputy governors who are a minority, does not
add value to the policy making of a central bank. Thus, in countries like Sri
Lanka where deputy governors are not vote carrying board members but
only in attendance at board meetings, an opportunity is provided for board
members to consult them on important policy issues.
However, for deputy governors to perform this job effectively, they should
be well versed in all aspects of central banking and global developments in
addition to having a detailed institutional memory which the board can tap
whenever it has doubts about any policy action being contemplated.
John Exter: Governor should be of unquestioned integrity
In the case of Sri Lanka, the governor who heads the Monetary Board
should be a person with wide experience and knowledge in economic,
financial and banking matters to lead the Board as well as the Central Bank
in the proper direction.
John Exter elaborated on this in the Exter Report as follows: The governor
should be a man of recognition and outstanding competence in and
understanding of the economic and financial problems of Ceylon, and of
unquestioned integrity and responsibility (p 16).
This is not explicitly laid down in the Monetary Law Act under which the
Central Bank has been set up in Sri Lanka. It is therefore left for the
appointing authority to take it into account when he selects a particular
person as the governor of the Central Bank. However, in many central
banking legislations, as noted by Exter, this has been incorporated as a
guidance to the authority which appoints the governor. This omission by
Exter has led in Sri Lanka to appoint people who do not possess these
qualifications to the post of governor of the Central Bank with subsequent
disastrous results.
Sri Lankas method of appointing governor and board members is defective
The procedure for appointing the governor and Monetary Board members in
Sri Lanka is far from ideal. In the case of the governor, in terms of Section
12 of the Monetary Law Act, the President can appoint anyone as governor