Devaluation, central banks (II)

From Friday

Last week, I explained why the kwacha was devalued and the likely consequences. This week, I will talk of the aim of devaluation and roles of central banks.

The aim of devaluation is to discourage importation of goods which we are making or we can easily make; hence, economise on foreign reserves.

When devaluation has pushed prices of imports up, people turn to locally made goods as they become much cheaper than foreign ones.

In buying local products (Buy Malawian), they will not only be helping the growth of local enterprises but also facilitate the creation of new jobs.

If, however, there is no domestic substitute for the imported goods, then there will be no choice but to buy the foreign products at inflated prices.

This will hurt the consumer. Devaluation could generate inflation; hence, there must be safeguards against it.

Devaluation is one way of reinvigorating the economy. I will, however, not dwell much on this subject.

Roles of the central banks

The kwacha has been devalued, yes. But by who? The Reserve Bank of Malawi (RBM) or by decision of both government and RBM?

I now want to look at roles of central banks.

Almost every country has a central bank. It is both a symbol of sovereignty and a necessity.

There are three general approaches of central banks.

l     Multiple objectives

Many central banks have general goals of maintaining economic stability. Among the specific objectives are low and stable inflation, low employment, rapid economic growth, coordination with fiscal policy and a stable exchange rate.

According to History of Malawi, volume 2, RBM was established before independence to do the following:

l     Safeguard the international value of our currency. This is where devaluation or no devaluation comes in.

l     Promote monetary stability. This means RBM ensures that the purchasing power of the kwacha is steady enough to prevent inflation. Many central banks have adopted inflation management as one of their roles. The central bank is mandated to ensure that the economy is not burdened with double digit inflation.

Exchange rate targeting

Here as in the case of RBM much attention is to be paid to external value of a currency.

The most powerful central bank in the world is the Federal Reserve Bank of the United States. This is the bank that issues the most valued reserve currency, the dollar. Its functions are:

• Conduct monetary policy by selling short-term interest rates.
• Maintain the stability of the financial system and to act as a lender of last resort with the American banking system.
• Supervise and regulate banking institutions.
• Provide financial services to banks and the government.

Central bank independence

One of the questions most economists and policy makers ask is whether a central bank should act independently. For example, should it devalue a currency even if the Minister of Finance is against the idea?

There are three or four macro-economics aggregates which any government these days exists to manage. These are economic growth, inflation, unemployment rates.

In tackling, any of them a government often finds it worsens the other.

When a government wants to reduce inflation, it raises (through its central bank) the interest rate. Higher interest rates discourage borrowing by businesses and projects are suspended, resulting in less money in circulation. This causes inflation to fall. This is welcome.

But cancelling projects means also laying workers off and creating unemployment. This is undesirable. It makes a government unpopular.

If a central bank is independent, it might be more worried about inflation than unemployment and, therefore, raise interest rates.

A democratic government which is about to face fresh general elections would not be comfortable with rising unemployment because unemployed people are likely to vote for the opposition.

Economic growth normally requires that economy wide prices should be rising. There is always the danger that the economy may be overheated, economic growth may be accompanied by double digit inflation.

Central banks are usually staffed by economists or bankers who are not elected by the people. They are less likely to worry about the elaborate. But a political party must always be sensitive to public opinion or else will lose the next votes.