Vantage View: How independent are Arab central banks?

The objectives and functions of Arab Central Banks have changed over the years as their emphasis shifted from issuing currency and supervising banking activities to reinforcing banking legislation, fighting fraud, applying capital adequacy ratios, combating inflation and maintaining economic and exchange rate stability.

Besides executing sound monetary policies, the role of the Central Bank is to provide a credible regulatory framework and effective supervision, one that promotes strong standards but is also market-friendly.

A strong regulatory context helps create market and consumer confidence, and generates a positive reputation that is essential for a prosperous and successful banking sector.

Strong regulation does not mean a "zero-failure" regime. Financial institutions, like other commercial enterprises, are in the business of risk-taking. Occasional market failures are to be expected.

The job of the central bank is to ensure that such failures are sufficiently rare that they do not undermine market confidence, nor do they impact depositors and the public at large.

The rise of public debt in several Arab countries in the 1980s forced central banks to put more emphasis on helping governments to manage their debt and finance their budget deficits.

In the process, central banks became subservient to the finance ministries in their respective countries and many of them lost their independence when managing monetary policy.

At the other extreme, in certain Arab countries such as Saudi Arabia, the government is prohibited by law from borrowing directly from the central bank.

In other Arab countries such as Jordan, Oman, Qatar and UAE, central banks have their own boards of directors which give them more independence to run their activities.

Central Banks replaced monetary agencies, starting with Kuwait in 1969, Oman in 1974, the UAE in 1980 and Qatar in 1993.

While the role of monetary agencies in the past was limited to issuance of currency, those agencies that still exist today in Saudi Arabia and Bahrain are quite independent and have more advanced laws, functions and procedures than most other central banks in the region.

In a world of increasingly mobile capital, countries cannot choose to have a fixed exchange rate peg and at the same time maintain an independent monetary policy.

Domestic interest rates should follow those on the dollar (in case of dollar peg), even if the country's economic cycle is not in sync with that of the U.S.

By following a fixed dollar peg, Jordan and the six Gulf countries have in effect given up the full control of their domestic interest rates, with the major up or down cycles of these rates being determined by the Federal Reserve of the U.S.

This means putting more pressure on fiscal policy in those countries to be sound and in balance. One way to measure the independence of the central bank is to consider the period of the governor's term and how often it is renewed.

The longer the period the less exposed the governor will be to political pressure emanating from the change in government.

A number of Arab central bank governors and their deputies have so far enjoyed very lengthy terms which exceeded that of their peers at the more independent central banks worldwide.

In Saudi Arabia, for example, the present governor has been in his post since 1983, while his term or that of any of his deputies officially lasts for four years and can only be renewed by a royal decree.

It is difficult to rely on a set of laws and standard procedures to evaluate the degree of independence of a central bank.

The way these laws are applied in practice and the strength of the central bank governor and his ability to withstand pressure from the government will increase the degree of independence of the central bank.

For example, an examination of Bahrain Monetary Authority's laws shows similarity to those of other central banks in the region.

However, in view of the striking development of Bahrain's financial position in the last two decades, the institution has obtained a freer hand in executing monetary policy and in monitoring the banking sector.

In other words, the more diversified and sophisticated the local financial market, the more latitude will the central bank have in choosing ways to implement monetary policy.

But since one of the prime objectives of the monetary policy is to ensure price and economic stability, the central bank should not be subjected to abrupt or severe changes in fiscal and financial polices.

For this reason, central banks in countries like Egypt, Algeria, UAE and Jordan have introduced rules and regulations that limit the government lending to a certain percentage of the budget's revenues.

Jordan, for example, had set a ceiling for public debt to GDP at 80 per cent.

Central banks in their normal course of activities do not try to target asset prices directly. They merely respond to stock movements as they affect household wealth and the cost of capital to businesses, and hence domestic demand and eventually inflation.

But as households get richer, living more from investments and less from monthly wages and stipends, and companies' ability to raise capital becomes more dependent on the financial markets and less on banks, share prices can easily act as the biggest source of volatility in the economy.

Central banks in Europe and the U.S. have confronted this challenge in the past three years, and Arab central banks should have the necessary financial instruments at hand to help combat an equity bubble or a crash in their respective financial market, if and when it happens.

Taking all this into consideration, the central banks of Jordan, UAE, Oman and the monetary agencies of Saudi Arabia and Bahrain have a high degree of independence, followed by the central banks of Kuwait, Qatar, Lebanon and Morocco where governments still borrow directly from the central bank, influencing in the process interest rates and monetary policy.

Countries where the central banks are seen to have less independence and control on monetary policy include Tunisia, Egypt and Algeria.

The author is Jordan-based CEO of Jordinvest.