The New Face of Central Bank Policies and Its Reflections o n Developing Countries

1. The New Face of Central BankPoliciesand Its Reflections onDeveloping Countries Dr. Aylin Abuk Duygulu Dokuz Eylul University, Department of Economics aylin.duygulu@deu.edu.tr

2. Old-Fashion Central Banking • Central Banks (CBs) consider developmental issues. • Monetary policy has a critical role to play in growth (Epstein and Yeldan, 2006). • CBs have some monetary policy tools which are direct instruments to affect the economic sectors of high priority. • Direct instruments: such as credit allocation techniques (subsidized interest rates, credit ceilings) and capital controls.

3. CBs have more than one goals (employment, growth, price stabilization) so need more instruments (Jan Tinbergen: you need to have as many instruments as targets) • Virtually CBs are -financing governments( so they are not independent), - managing exchange rates, - supporting economic sectors (Epstein, 2006).

4. Most historians identify the following functions as being historically essential to the operations of CBs (Epstein,2006): • Unifying and issuing the country’s bank notes, • Acting as the government’s bank, • Acting as the commercial banks’ bank, • Serving as a lender of last resort to the banking and even the financial system as a whole, • Conducting monetary policy to manage the foreign exchanges and the price level, • Conducting monetary policy to manage the overall level of economic activity, • Allocating credit to promote national goals.

5. In addition to these, there are at least three other roles of CBs: -The Distributive role (the effects of CB policies on different class and groups) -The Political role (whether or not the CB is independent from the government) -The Allocative role (the effects of CB policies on the profitability and accessibility to credits)

6. Modern Central Banking • In modern central banking, CBs attempt to (Epstein,2005): - keep inflation at a very low level, - reduce central bank support for government fiscal deficits, -help manage the country’s integration into world trade and financial markets, -reduce the influence of democratic, social and political forces on CB policy.

7. We can name these attempts as “neo-liberal approach to central banking” (Epstein, 2006). • This neo-liberal approach has following key features: - CB independence, - a focus on inflation targeting, - the use of indirect instruments of monetary policy.

8. Why modern central banking can be named as a neo-liberal approach? • The main points of neo-liberalism include (Martinez and Garcia,2000): - The Rule of the market - Cutting public expenditure for social services - Deregulation - Privatization - Eliminating the concept of “the public good” or “community” and replacing it with “individual responsibility”.

9. Key features of neo-liberal approach to central banking

10. CB Independence • Monetary policy conducted by independent CBs played an important role in reducing inflation rates. • What is CB independence? • “CB independence implies first and foremost that the CB should not be subject to pressure from the government to finance government activities (deficits)” (Epstein, 2006)

11. Inflation targeting • Inflation targeting is a monetary policy strategy which focuses on only low inflation rates. • The focus on inflation means that the CB should not be concerned with other goals such as promoting full employment, supporting industrial policy or allocating credit to the sectors of high priority.

12. Rational behind the inflation targeting stems from the old monetarist argument that in the long run,monetary policy can only affect inflation. However this theoretical tradition depends on invalid assumptions such as neutrality of money.

13. It’s expected that inflation targeting will (Epstein,2005); - reduce the rate of inflation, - enhance the credibility of monetary policy, - reduce the sacrifice ratio associated with contractionary monetary policy, - help to attract foreign investment.

14. Argument 1: Reduce the rate of inflation • Michael Kumof (2000) stated that the suitability of inflation targeting was first discussed in Masson, Savastano and Sharma’s (1997) studies. They find that the policy is unsuitable for most emerging markets (i.e. developing countries), based on two objections:

15. First: for emerging markets the exchange rate remains an important additional objective of monetary policy which is bound to lead to conflicts with the inflation target. • Second: inflation targeting may no longer be applicable to all emerging markets what it means for the majority of them is fiscal dominance.

16. In the introductionof their research paper, Victor Polterovich and Vladimir Popov argue that considerable number of empirical studies demonstrated that inflation has a negative impact on growth only if it exceeds a certain threshold. Otherwise low inflation has no impact or even accelerates growth (in accordance with the World Bank’s classification of countries - low income: inflation rate %11-16; lower middle: inflation rate %15-21; upper middle: inflation rate %4-5).

17. Countries that adopt inflation targeting achieve lower inflation rates by causing recessions and by throwing people out of work (the increase in productivity ???). It’s seen that inflation targeting strategy has been apparent inability to reduce the sacrifice ratio (Epstein, 2005). ______________ Sacrifice ratio:the loss of output or employment associated with a given reduction in inflation (Heintz, 2006) or the unemployment costs of fighting inflation (Epstein, 2005). Argument 2: Reduce the sacrifice ratio associated with contractionary monetary policy

18. Some Problems Originating fromthe Inflation Targeting Strategy

19. A CB that adopt inflation targeting has only one instrument, namely short-term interest rate. The inflation targeting CBs reduceinflation by raising interest rates because monetary authorities frequently use short term interest rates as a weapon against inflation. Instrument Problem

20. However, this policy leads to an overvaluation of the exchange rate because of the capital inflows. • Rising interest rates affect the short term capital flows, as capital flows into a country, the nominal exchange rate appreciates. • Exactly under this strategy, low inflation targets can lead to appreciation of the real exchange rate. This reduces export competitiveness but increases imports (Heintz, 2006). In other words, negative effects occur on net export.

21. We know that exchange rate is an important factor in determining inflation rate in developing countries, CB can not be completely freeto let the exchange rate float.

22. What is recommended by the IMF and the Orthodoxy? • Currently recommended by the IMF and the orthodoxy: - A fully opened capital account- no capital controls or other restrictions on capital mobility, - A pure floating, market determined exchange rate-non-intervention in the foreign exchange market, -An inflation targeting monetary policy.

23. This combination has an important negative attribute (Frenkel,2005): • The volatility of capital flows is transmitted through the volatility of nominal and real exchange rates and relative prices with adverse effects on employment and growth.

24. Another important issue is capital account liberalization and unstable financial flows are needed to increase reserves as protection. In the absence of any exchange rate target officially stated (because a pure floating exchange rate), the need for holding foreign reserves at the CBs should have been minimal (Epstein and Yeldan,2006). The Cost of Accumulating Reserve

25. Rodrik (2006) stated that developing countries began to accumulate reserves as a consequence of financial liberalization and globalization and the increase in developing country’s reserves is related to changes not in real quantities (such as import or output) but in financial magnitudes.

26. The need for reserve can be explain by the need for liquidity. • Liquidity,in turn, could be achieved via three strategies (Rodrik,2006): - Reducing short-term debt, - Creating a collateralized credit facility, - Increasing foreign exchange reserves of the CBs.

27. However accumulating reserves is also costly. • The costs include: - The spread between the yield on liquid reserve assets and the external costs of funds, - The sterilization policy causing an increase of interest rates, - Not using this source on the creation of employment or education.

28. Dani Rodrik (2006) says that the spread between the yield on liquid reserve assets and the external costs of funds represents the social cost of self-insurance. • In his study he calculated this cost is close to 1 percent of GDP.

29. When CBs attempt to compensate the liquid effect of accumulating reserve, they sterilizing them by selling domestic liabilities from their portfolio may even bid up local interest rates (Frenkel and Taylor,2006). • So this can cause more capital inflows again and appreciation of exchange rate.

30. The Argument of Trilemma • The impossible trinity-trilemma says that CBs can only have two out of three of the following options: open capital markets, a fixed exchange rate system and an autonomous monetary policy. • In an (internationally) financially integrated economy with high capital flows, monetary policy is bounded only one instrument-short term interest rate.

31. It can be concluded that without any capital control mechanisms or any exchange rate arrangements, a central bank using only short term interest rates can not achieve low inflation rates with a low sacrifice ratio.

32. Low Inflation Rates-For Whom? • Low inflation rates or price stability is for whom? • Inflation targetinglow inflation ratesbut high sacrifice ratio, loss of CB credibility. • So why the IMF and the Orthodoxy insist on inflation targeting?

33. Epstein and Power (2003) answer this question: Focus on fighting inflation and keeping it low and stable is in the interest of rentier groups in these countries. • Who is rentier? • Keynes refers to the rentier as the functionless investor who generates income via his ownership of capital. • Kalecki’s definition: it represents the income received by owners of financial firms + the return to holders of financial assets generally.

34. High inflation rates decrease the value of financial wealth. • In addition, higher interest rates attractfinancial flows searching onlyhigh gains. • Financial liberalization and liberalization of the capital account created more financial instability, and thereby, created the need for economic actors to purchase more financial products and create more profits for finance (Epstein and Power ,2003) .

35. Epstein and Power (2003) present that in many countries, higher real interest rates and lower inflation increase the rentier shares of income. • In a neo-liberal world, the countries are conditioned to adopt and maintain contractionary monetary policies (i.e. inflation targeting) in order to secure “investor confidence” and “international credit worthiness” (Epstein and Yeldan,2006). • So, CBs are independent from government deficits but dependent on “investor confidence”.

36. The case of Turkey

37. Central Banking in Turkey • Central Bank of Republic of Turkey (CBRT) used to act as an agent of development before the mid1980s. • But in the 1990s, like most CBs, CBRT gave its priority to the macroeconomic stability- a combination of price stability and financial stability. • To achieve the stability objective, CBRT started to use indirect instruments heavily, such as open market operations.

38. In 2001, CBRTannounced its independence after a change in its legislation. • In the period of 2001-2006, CBRT adopted implicit inflation targeting strategy. • In 2006, CBRT announced to adopt explicit inflation targeting.

39. Table 1:Main Macroeconomic Indicators of Turkey (Sources: CBRT and SIS)

40. Assessing the Inflation Targeting Strategy in Turkey

41. Table 2:Inflation, Growth and Unemployment in Turkey Sources:CBRT and SIS

43. Volatility of growth and inflation in Turkey (2001-2006) Volatility of Growth : 1.527 Volatility of Inflation (CPI) : 0.9785

44. Table 3:Foreign Direct Investment Inflow by Sectors in Turkey (Million $) Source: T.R. Prime Ministry, State Planning Organization

45. Table 4:Foreign Direct Investment Inflow by Sectors in Turkey (%) Source: T.R. Prime Ministry, State Planning Organization

46. Table 5: Real Exchange Rate, Current Account Balance and Central Bank Reserves in Turkey Sources: CBRT and SIS

47. Table 6: Main Components of the Balance Of Payments (Million $)

48. Conclusion

49. Central Bank (CB) policies are of great importance for both developed and developing countries. In the past, we know that many developed countries have used some monetary policy tools to reach development objectives as an important part of their tasks. Now, most developing countries want to adopt a ‘new’ monetary policy strategy namely ‘inflation targeting’ which only focus on the ‘price stability’. In this strategy, we see that CB operations have changed from using direct instruments to ‘market-based’ operations like using indirect instruments.

50. On the other hand, these new CB policies also raise some problems especially in developing countries, for example rising current account deficits, unemployment and unstable growth rates. These problems are often related to the financial liberalization-unstable financial flows- which eliminates capital controls and exchange rate controls.