Monday, November 28, 2011

Role of Central Banks in a Less and More Developed Economy

In developed nations, central banks conduct a wide range of banking, regulatory, and supervisory functions. They have substantial public responsibilities and a broad array of executive powers. Their major activities can be grouped into five general functions:
(1) Issuer of currency and manager of foreign reserves: Central banks print money, distribute notes and coins, intervene in foreign-exchange markets to regulate the national currency's rate of exchange with other currencies, and manage foreign-asset reserves to maintain the external value of the national currency.
(2) Banker to the government: Central banks provide bank deposit and borrowing facilities to the government while simultaneously acting as the government's fiscal agent and underwriter.
(3) Banker to domestic commercial banks: Central banks also provide bank deposit and borrowing facilities to commercial banks and act as a lender of last resort to financially troubled commercial banks.
(4) Regulator of domestic financial institutions: Central banks ensure that commercial banks and other financial institutions conduct their business prudently and in accordance with relevant laws and regulations. They also monitor reserve ratio requirements and supervise the conduct of local and regional banks.
(5) Operator of monetary and credit policy: Central banks attempt to manipulate monetary and credit policy instruments (the domestic money supply, the discount rate, the foreign-exchange rate, commercial bank reserve ratio requirements, etc.) to achieve major macroeconomic objectives such as controlling inflation, promoting investment, or regulating international currency movements. Sometimes these functions are handled by separate regulatory bodies.
Central banks are capable of effectively carrying out their wide range of administrative and regulatory functions in developed nations primarily because these countries have a highly integrated, complex economy; a sophisticated and mature financial system; and a highly educated, well-trained, and well-informed population. In developing countries, the situation is quite different. LDCs may be dominated by a narrow range of exports accompanied by a much larger diversity of imports, the relative prices (the terms of trade) of which are likely to be beyond local control. Their financial systems tend to be rudimentary and characterized by:
(1) foreign-owned commercial banks that mostly finance domestic and export industries.
(2) An informal and often exploitative credit network serving the bulk of the rural and informal urban economy.
(3) A central banking institution that may have been inherited from colonial rulers or operates either as a currency board issuing domestic currency for foreign exchange at fixed rates or simply to finance budget deficits.
(4) A money supply that is difficult to measure (because of currency substitution) and more difficult to regulate.
(5) An unskilled and inexperienced workforce unfamiliar with the many complexities of domestic and international finance.
(6) A degree of political influence and control by the central government (over interest rates, foreign-exchange rates, import licenses, etc.) not usually found in more developed nations.
Under such circumstances, the principal task of a central bank is to instill a sense of confidence among local citizens and foreign trading partners in the credibility of the local currency as a viable and stable unit of account and in the prudence and responsibility of the domestic financial system. Unfortunately, many LDC central banks have limited control over the credibility of their currencies because fiscal policy - and large fiscal deficits - call the tune and must be financed either by printing money or through foreign or domestic borrowing. In either case, prolonged deficits inevitably lead to inflation and a loss of confidence in the currency.
Given the substantial differences in economic structure and financial sophistication between rich and poor nations, central banks in most of the least developed countries simply do not possess the flexibility or the independence to undertake the range of monetary macroeconomic and regulatory functions performed by their developed-country counterparts.

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