When he talks about the place where he spent the last five years, Brazil’s former Central Bank President Gustavo Franco doesn’t mince words.
“The central bank should have sole responsibility for monetary policy,” said Franco, during a recent interview with LatinFinance on his balcony overlooking the ocean in Rio de Janeiro. “And the governors should have set terms, ideally not coinciding with the term of the president of the republic,” he said. “These are simple details that I don’t think are very controversial in the end. They become controversial because every time there is a problem, the central bank is blamed for that problem.”
He should know. Franco was forced to resign from the central bank in January, after the government decided to disregard his objections and alter the narrow band system in which the real floated. After the government bungled the operation, and the subsequent currency devaluation nearly cost the country what was left of its macroeconomic stability; both Congress and local public opinion put the fault squarely on the back of interim bank president Francisco Lopes. To make matters worse, Lopes was implicated-although never convicted-in a scandal involving insider information that cost him his job only days later.
Depoliticizing the Bank
The rapid turnover of central bank presidents renewed debate within Brazil and in the international community about the need to give the central bank more independence from the political pressures that could contaminate monetary policy decisions. While experts agree that some steps need to be taken to provide the bank with greater independence, they diverge on just how far that process should go. What is certain is that as Brazil struggles to get its finances in order, a strong and vigilant central bank is crucial to success.
“Our view is textbook by now that the best we can do here is work toward a stable monetary environment,” said Central Bank President Arminio Fraga (see page 25 for interview with Fraga). “The idea is to set up the central bank in a way to make sure that short-term pressures don’t end up interfering in any way with these longer-term goals. We are trying to do that here.”
Fraga says, and experts agree, that the most important first step toward depoliticizing monetary policy is to provide fixed-term mandates for the central bank president and board of directors, who now serve at the discretion of the president. The mandates would provide protection against firing as long as the members worked in accordance with the long-term goals of the bank.
In order to legislate the mandates, though, Brazil’s constitution would have to be amended by Congress during a busy year and on the back of a Senate investigation into illegal activities by the central bank during the devaluation.
Fraga says that he expects action by Congress soon. But Winston Fritsch, president of Dresdner Bank in Brazil and former policy secretary for Cardoso when he was finance minister, warns: “One sees a perpetual willingness by Congress to have more control over the central bank rather than less.”
In Favor, For Now
Since Fraga was approved by the Senate and took up his post in March of this year, some of the furor over central bank independence has died down. Fraga, like Franco before him, is considered a strong leader, who has the support of President Fernando Henrique Cardoso to direct the bank with an independent hand.
In fact, all three of Cardoso’s Bank presidents-Fraga, Franco and Gustavo Loyola-say that they were given enough independence to run the bank’s operations largely without political pressure.
Now that the economy is faltering, though, and municipal elections are just around the corner next year, there is no guarantee that that independence won’t be checked.
“What is happening now is that the central bank has a policy that is supported politically-reducing the interest rates, etc.,” said Loyola, who is now an economist at Tendencias Consultoria. “If the central bank has to adopt a posture that is tougher in terms of monetary policy, you are going to see an increase in pressure and the autonomy of the bank will once again be threatened. Today, the situation is very precarious, very tenuous, very weak.”
It is expected that central bank vulnerability to short-term political pressures will be partially resolved by the government’s newly adopted monetary policy of inflation targeting.
“The [inflation] goals are set by the finance minister with the support of the president, and the understanding is that we will be given the freedom to pursue these goals,” said Fraga.
“In the end it helps move things away from short-term horizons-where typically the temptation to print a little money materializes-to a longer-term horizon where you can act according to what is right, which is not to think that you can get growth out of printing money,” he added. “Growth comes from saving and investing and educating your people. And the best the central bank can do is stay out of the way and not make it too complicated. That is really what we believe in.”
Too Many Chiefs?
From a hierarchical perspective, Brazil’s central bank is subordinate to a group called the National Monetary Council. Over the years, the membership on the council has varied, but after the Real Plan was created in 1993, it was reduced to three: the finance minister, the minister of planning, and the president of the central bank. The Council, which receives its budget from Congress, is responsible for the overall direction of monetary policy and sets the country’s new inflation-targeting goals. The direct hand of politically appointed ministers in the country’s monetary policy is one of Franco’s strongest objections.
“It was the determination of the (Cardoso administration) that ordered the National Monetary Council to order the central bank to set the inflation targets,” Franco said. “The way it was done puts decisions over monetary policy in the hands of the president of the Republic. I don’t think that is right.”
While Franco supports removing monetary policy decisions from the council entirely, other experts suggest that the group’s structure be merely altered to include more members, with a majority of votes given to central bank directors. They say that Brazil’s still-recovering system requires a certain amount of coordination between fiscal and monetary policy. In one example, the finance minister or other government appointees could sit on the board without the right to vote. Chile’s central bank, where the finance minister is given limited powers to postpone board decisions, is another often cited example.
To its credit, the Brazilian government has taken some strides over the last 15 years to bring more independence to the central bank.
Legislation was passed to separate functions of the central bank and the treasury. In 1986, the Brazilian government severely limited the extent to which the federally owned Banco do Brasil could freely draw funds from the central bank.
Then, in 1997, the government created the Monetary Policy Committee (Copom) of the central bank, which serves as the guardian of the country’s interest rates in the style of the US Federal Reserve. The committee lends transparency to the central bank’s interest rate decisions by publishing monthly reports on the state of the economy and the actions of the bank.
Franco worries, though, that the progress toward independence has been halted by the change to a flexible exchange rate regime that is held in check only by inflation targets set ultimately by the Cardoso administration.
Earlier this year, the government announced that the central bank would target 8% inflation for this year, 6% in 2000 and 4% for 2001.
“You project something out, and there is a 100% probability that it is going to be revised in six months in either direction,” said Franco. “If the fiscal disequilibrium is not addressed, the inflation target will need to be revised. Why are you going to attack fiscal disequilibrium if it is an unpopular proposal?”
Other economists agree that Brazil is walking a thin line of credibility on the fiscal side, which could have serious effects on the central bank’s ability to independently pursue the inflation-targeting model.
“Inflation targeting in Brazil was premature,” said Loyola. “One of the prerequisites for inflation targeting to work is that there is no fiscal dominance. But in Brazil, the fiscal situation is terrible. The fiscal situation can limit inflation targeting when the inflation target is unbelievable because you have fiscal restrictions that are so strong.”
The central bank’s efforts are bolstered by continued public support for inflation control within Brazil. “The key element of central bank independence is a clear mandate by public opinion,” said Fritsch. “After years of high inflation in South America, I think the sudden shift toward low inflation gave the politicians that fought inflation tremendous popularity. This popularity may vanish over time, but it has had tremendous resilience. In Brazil and Argentina, despite high unemployment, inflation control is still considered a primary goal.”
In the end, economists would like to see a central bank that is modeled after its European counterparts, which act as guardians of the national currency, guaranteeing its equilibrium in the financial markets and the economy, protecting its value, and preventing government spending that is backed by the printing of money. The US Federal Reserve system, with its strong participation from regional federal banks, is not considered practical for a country like Brazil, whose federal government is in a constant battle to gain control over unruly states.
But the central bank’s need for independence does not stop at monetary policy. The bank also fulfills a crucial watchdog role, which can be compromised by political interference.
Allen Rodriguez, chief economist for General Motors in Latin America and former US Treasury official says that there are major risks when a central bank is not fully independent because pressures can be exerted that limit or prevent intervention or write-offs of non-performing loans. “That is what you see in Mexico,” he said. “The regulations are extremely lax in the writing off of non-performing wealth. And in Brazil, there are still some very large public banks that don’t, by their nature, make credit-worthy decisions.”
Other Financial Houses
The biggest worry lately has been Banco do Brasil, which got itself into trouble through loans to the city of São Paulo, and may require recapitalization. Although the incestuousness between Banco do Brasil and the central bank was officially untangled years ago, the shareholders are the same, which means that political pressure is still a factor in the relationship between the two institutions. Especially since Banco do Brasil continues to play a key role in the risky financing of Brazil’s agriculture and foreign trade. Experts say that a true delinking of the two institutions will only come when Banco do Brasil is privatized, which can only happen after a market-driven alternative to agriculture and trade finance can be developed.
While the relationship between the treasury and the central bank is clearer, tension still remains as the Treasury turns to its bank of last resort to help fund a government that is running a huge budget deficit. The fact that the treasury paper and the central bank issuances are almost identical in the market adds to the confusion. To give more independence to the two institutions is not just a matter of legislation, economists say.
The fiscal deficit must also be brought under control and the market for medium and long-term paper needs to open.