Are we in a new age of central banking in emerging markets?
Speech by Mr Agustín Carstens, General Manager of the BIS, at New Age of Central Banking in Emerging Markets Conference, Budapest, Hungary, 17 March 2023.
It is a great pleasure to be here in Budapest today. I would like to thank Corvinus University for awarding me an Honorary Doctorate this morning and for organising this conference. I am deeply honoured and look forward to our discussions today.
The title of today's conference is one that is close to my heart. After all, I spent most of my career working at an emerging market central bank, the Bank of Mexico.
I believe it is no exaggeration to say that emerging market central banks have entered a new age. In past decades, rapid rises in advanced economy interest rates, of the kind that we have seen over the past year, would often trigger capital flight, disrupt exchange rates and cause economic upheaval in emerging markets. Yet most such countries have emerged from the past year comparatively unscathed. That speaks to the enormous strides that emerging market central banks have made in their policy frameworks and institutional capacity.
But even in this new age, there are certain core central banking principles that remain current, as well as problems that will always recur. Today, these apply as much to advanced economy central banks as their emerging market counterparts.
The most important of these principles is the essential need for trust in money. And that is what I would like to talk about today.
Why did I choose this topic?
Well, recent years have seen several troubling developments which, if not addressed, could start to threaten society's trust in money. I speak specifically of challenges to fiat money, the return of inflation and threats to financial stability.
In the past week alone, we have seen bank runs, the near collapse of a major cryptocurrency and huge volatility in bond and equity markets, all amid stubborn global inflation. These events prompted me to underline in this conference the indisputable importance of trust as a key element of our current financial system.
I will begin by recalling the most fundamental aspect of central banking: the nature of money. The social convention of money, as we know it today, is based on the trust placed in it by the public. And, as money is the basis of the entire financial system, the system's stability depends on that trust.
Fiat money is an asset with no intrinsic value. Its value derives from the social convention that underpins it, together with the institution that enables it to function – the central bank. Money only has value today if the public knows that others will respect that value, today and in the future. This ensures that when a person wants to use money, it will be accepted and that the payment will be final. Thus, its value clearly comes from trust. This is why the issuer of money is so powerful. However, this power carries with it a great responsibility: those who abuse their authority to issue currency deprive money of its value and will be rejected by society.
The consequences of the state abusing its privilege of issuing money can be disastrous. As is well known in emerging market economies, abuses can range from high inflation and sharp exchange rate depreciations to the abandonment of the national currency in favour of a foreign one (dollarisation) or, in the extreme, a return to barter (after a hyperinflation). Further consequences can include severe financial instability, with severe costs for society in terms of economic growth, employment, inequality and wealth. All these consequences of the loss of trust in money have been the main motivation for the autonomy of central banks. After all, autonomous central banks are nothing more than an institution of state with the key mandate of preserving the national currency's purchasing power. Autonomy is the social device whereby society's trust in the central bank is maintained. It is encouraging that most emerging market central banks are now autonomous.
But autonomy by itself is not enough. Central banks also have to earn the credibility they need. Let's consider what monetary authorities must constantly do to preserve people's trust in money. They must make monetary arrangements that allow them to anchor inflation expectations and thus keep up the purchasing power of the currency they issue. Over recent decades, most central banks, including many in emerging markets, have converged on inflation targeting regimes as the best way of doing this.
How does inflation targeting work?
Central banks do not directly control inflation. However, their policy tools can influence it. An inflation targeting central bank commits itself to using its tools to achieve the targets. If the public trusts the central bank to do what is required to keep inflation close to target, then that target, rather than current inflation, becomes a key reference for people in making their price and wage decisions, leading to low and stable inflation. In this situation, variations in inflation are usually transitory and reflect changes in relative prices. Inflation becomes self-equilibrating.
But trust gained can easily be lost if society doubts the central bank's commitment to the objective of maintaining price stability. This is one of the reasons why the recent rise in inflation in virtually every country is a cause for concern. Some generations are experiencing the risk of the economy shifting to a high-inflation regime for the first time. And once this transition starts, it can become increasingly difficult to stop. Therefore, it has been appropriate that most central banks have been prudently tightening monetary policy through higher interest rates to restore price stability. This response should continue as necessary, for only by resolve, perseverance and success in this task can trust in money be preserved.
It is well known that the money issued by the central bank, known as primary money, is not the only money that circulates in a modern economy. Commercial bank money, the result of commercial bank intermediation, is also fundamental to the monetary system. This type of money takes the form of bank deposits and credits. For most people, primary and commercial bank money are indistinguishable, which is by design. Over time, institutional arrangements have been developed to ensure that society's trust in primary money also extends to bank money.
A two-tiered monetary system is the crucial element. The central bank lays the foundation, and on the first floor are commercial banks. The keys are that interbank payments be ultimately settled on the central bank balance sheet, through the exchange of primary money between commercial banks, and that the public can freely convert commercial bank money into central bank money – as when you withdraw cash from an ATM. These arrangements guarantee the finality of payments and the singleness of bank money. The ultimate settlement of the banking system at the central bank is made possible by the central bank's high degree of discretion in creating liquidity through its lending to the banking system. At times of great instability, it can provide liquidity through its well known lender of last resort function. Thus, insofar as there is trust in primary money, the central bank transfers this to the banking system.
Settlement on the central bank balance sheet and free exchange into central bank money are not, however, enough to ensure trust. The banking system must also remain clearly solvent, and be perceived as such. As we saw in recent days with Silicon Valley Bank, even the slightest doubt about a bank's financial condition can be deeply destabilising. Reflecting the high social costs of banking crises, the system is extensively regulated and supervised. There is also deposit insurance and the central bank's ability to act as lender of last resort, which exists to mitigate potential bank runs. All these layers of protection are intended to safeguard the public's savings, and they are essential to anchor the trust in both primary and commercial bank money.
To put into perspective the enormous value of the framework I have described, all of which supports trust in primary and commercial bank money, it is useful to refer to recent failed attempts to issue private money through technologies that allow transactions based on decentralised ledgers. These alleged forms of money function without central bank intervention, a lender of last resort or a reliable regulatory and supervisory framework. These have resulted in the proliferation of so-called cryptocurrencies, which guarantee neither payment finality nor a stable value, and so clearly do not possess the fundamental attributes of money. The collapse of the Terra-Luna crypto coins last year, and the behaviour of the so-called USDC stablecoin, which fell more than 10% below its par value at one point last week, are only the most recent examples. This is a further confirmation, if one is needed, that what sustains fiat money over alternatives based on novel technologies is the institutional framework and the social conventions that support it, which are precisely what makes money reliable for the public.
Let me conclude. In the foreseeable future, monetary policy should focus on bringing inflation back to levels consistent with central bank objectives. This process may run into obstacles, particularly in the final stretch towards eventual convergence with inflation targets. But it is essential to achieve this objective. Otherwise, the credibility of monetary policy would be called into question, as would the credibility of the autonomous central banks responsible for implementing it. At the same time, effective regulation and supervision of the financial system is essential to allow central banks to take the decisive monetary policy actions required to bring inflation down.
