This article first appeared in Forum, The Edge Malaysia Weekly on November 7, 2022 - November 13, 2022

Developing countries have long been told to avoid borrowing from central banks to finance government spending. Many have even legislated against central bank financing of fiscal expenditure.

Such laws are supposedly needed to curb inflation — below 5%, if not 2% — to accelerate growth. These arrangements have also constrained a potential central bank developmental role and the government’s ability to respond better to crises.

Improved monetary-fiscal policy coordination is also needed to achieve desired structural transformation, especially in decarbonising economies. But too many developing countries have tied their own hands with restrictive legislation.

A few have pragmatically suspended or otherwise circumvented such self-imposed prohibitions. This allowed them to borrow from central banks to finance pandemic relief and recovery packages.

Such recent changes have re-opened debates over the urgent need for counter-cyclical and developmental fiscal-monetary policy coordination.

But financial interests claim this enables central banks to finance government deficits, that is, monetary financing. Monetary financing is often blamed for enabling public debt, balance of payments deficits and runaway inflation.

As William Easterly noted, “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.”

Hence, calls for monetary financing are typically met with scepticism, if not outright opposition. Monetary financing undermines central bank independence — hence, the strict segregation of monetary from fiscal authorities — supposedly needed to prevent runaway inflation.

Recent International Monetary Fund (IMF) research insists monetary financing “involves considerable risks”. But it acknowledges that monetary financing to cope with the pandemic did not jeopardise price stability. A Bank of International Settlements paper also found that monetary financing enabled developing countries to respond counter-cyclically to the pandemic.

Cases of monetary financing leading to runaway inflation have been very exceptional — for example, Bolivia in the 1980s or Zimbabwe in 2007/08. These were often associated with the breakdown of political and economic systems, as when the Soviet Union collapsed.

Bolivia suffered major external shocks. These included then US Federal Reserve chair Paul Volcker’s interest rate spikes in the early 1980s, much reduced access to international capital markets and the collapse in commodity prices. Political and economic conflicts in Bolivian society hardly helped.

Similarly, Zimbabwe’s hyperinflation was partly due to conflicts over land rights, worsened by government mismanagement of the economy and British-led Western efforts to undermine the government of then president Robert Mugabe.

Former Reserve Bank of India governor Y V Reddy noted that fiscal-monetary coordination had “provided funds for development of industry, agriculture, housing and so on, through development financial institutions” apart from enabling borrowing by state-owned enterprises (SOEs) in the early decades.

For him, less satisfactory outcomes — for example, continued “macro imbalances” and “automatic monetisation of deficits” — were not due to “fiscal activism per se but the soft-budget constraint” of SOEs, and “persistent inadequate returns” on public investments.

Monetary policy is constrained by large and persistent fiscal deficits. For Reddy, “undoubtedly the nature of interaction between [fiscal and monetary policies] depends on country-specific situation”.

Reddy urged addressing monetary-fiscal policy coordination issues within a broad common macroeconomic framework. Several lessons can be drawn from the Indian experience.

First, “there is no ideal level of fiscal deficit, and the critical factors are: How is it financed and what is it used for?” There is no alternative to SOE efficiency and public investment project financial viability.

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

Third, “harmonious implementation of policies may require that one policy is not unduly burdening the other for too long”.

Zhou Xiaochuan, the then People’s Bank of China (PBoC) governor, emphasised central banks’ multiple responsibilities — including financial sector development and stability — in transitioning and developing economies.

China’s central bank head noted that “monetary policy will undoubtedly be affected by balance of international payments and capital flows”. Hence, “macro-prudential and financial regulation are sensitive mandates” for central banks.

PBoC objectives — long mandated by the Chinese government — include maintaining price stability, boosting economic growth, promoting employment and addressing balance of payments problems.

Multiple objectives have required more coordination and joint efforts with other government agencies and regulators. Therefore, “the PBoC … works closely with other government agencies”.

Zhou acknowledged that “striking the right balance between multiple objectives and the effectiveness of monetary policy is tricky”. By maintaining close ties with the government, the PBoC has facilitated needed reforms.

He also emphasised the need for policy flexibility as appropriate. “If the central bank only emphasised keeping inflation low and did not tolerate price changes during price reforms, it could have blocked the overall reform and transition.”

During the pandemic, the PBoC developed “structural monetary” policy tools, targeted to help Covid-hit sectors. Structural tools helped keep inter-bank liquidity ample and supportive of credit growth.

More importantly, its targeted monetary policy tools were increasingly aligned with the government’s long-term strategic goals. These include supporting desired investments, for example, in renewable energy, while preventing asset price bubbles and “overheating”.

In other words, the PBoC coordinates monetary policy with fiscal and industrial policies to achieve desired stable growth, thus boosting market confidence. As a result, inflation in China has remained subdued.

Consumer price inflation has averaged only 2.3% over the past 20 years, according to The Economist. Unlike global trends, China’s consumer price inflation fell to 2.5% in August, and rose to only 2.8% in September, despite its “zero Covid” policy and measures such as lockdowns.

Effective fiscal-monetary policy coordination needs appropriate arrangements. An IMF working paper showed, “neither legal independence of central bank nor a balanced budget clause or a rule-based monetary policy framework … are enough to ensure effective monetary and fiscal policy coordination”.

Appropriate institutional and operational arrangements will depend on country-specific circumstances, for example, the level of development and depth of the financial sector, as noted by both Reddy and Zhou.

When the financial sector is shallow and countries need dynamic structural transformation, the setting up of independent fiscal and monetary authorities is likely to hinder, not improve stability and sustainable development.

Understanding each other’s objectives and operational procedures is crucial for setting up effective coordination mechanisms — at both the policy formulation and implementation levels. Such an approach would better achieve the coordination and complementarity needed to mutually reinforce fiscal and monetary policies.

Coherent macroeconomic policies must support needed structural transformation. Without effective coordination between macroeconomic policies and sectoral strategies, monetary financing may worsen payment imbalances and inflation. Macro-prudential regulations should also avoid adverse monetary financing impacts on exchange rates and capital flows.

Poorly accountable governments often take advantage of real, exaggerated and imagined crises to pursue macroeconomic policies for regime survival, and to benefit cronies and financial supporters.

Undoubtedly, much better governance, transparency and accountability are needed to minimise both immediate and longer-term harm due to “leakages” and abuses associated with increased government borrowing and spending.

Citizens and their political representatives must develop more effective means of “disciplining” policymaking and implementation. This is needed to ensure public support to create fiscal space for responsible counter-cyclical and development spending.

Anis Chowdhury, a former professor of economics at the University of Western Sydney, held senior United Nations positions from 2008 to 2015 in New York and Bangkok. Jomo Kwame Sundaram, a former economics professor, was United Nations assistant secretary-general for economic development. He is the recipient of the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.

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