Central Banks’ Dual Role Dilemma And Monetary Policy Constraints: Reserve-Constrained Economy Perspective

The past three decades have witnessed an increasing importance and an enormous transformation in the reserve management function of central banks in reserve-constrained economies. Traditionally, central bank reserve management tended to be characterized by a simple custodial mandate of liquidity maintenance required for supporting exchange rate policy, meeting public imports, and servicing foreign debts of the governments. Over time, however, the reserve management function of central banks moved beyond the sole liquidity mandate, to include a portfolio management role with a strong emphasis on generating returns on reserves. This transformation has generated a sharp trade-off between the liquidity and portfolio management roles, creating what we call a “dual role dilemma” in the reserve management function of central banks. This thesis explores the underlying forces behind this novel dual role dilemma in central banks of reserve-constrained economies, and some of the key factors that exacerbate the dilemma. The thesis also examines the implications of this dilemma for monetary policy, specifically for reserve-constrained economies which have adopted inflation targeting regime. The thesis begins laying an excellent analytical framework for analyzing and understanding the forces underlying the dual role dilemma. It joins together the perspective of the international monetary asymmetry (anchored on the US dollar) and the global productive structure hierarchy (with reserve-constrained economies heavily rely on primary commodities). It then, provides empirical evidence of the existence of this dilemma based on a detailed qualitative study, combining insights from semi-structured interviews and focus group discussions with central bankers in three Sub-Saharan African countries: Botswana, Uganda and Zambia. This empirical evidence allows us to trace the historical roots and institutional characteristics that create and exacerbate the dual role dilemma in reserve-constrained economies. The thesis’ main results show that the dilemma has its roots in four adverse conditions faced by reserved-constrained economies: (a) their excessively volatile exchange rates and acute loss of monetary policy, (b) their chronically high external obligations, (c) their scarcity of reserves associated with the heavy reliance on primary commodities which faced extreme climatic vulnerability and price volatility, and (iv) the severe erosion of their reserve capital arising from ultra-low yields on reserve assets. Moreover, institutional characteristics, particularly weak fiscal policies, and financial fragilities are shown to exacerbate the dilemma in these countries. Having provided theoretical and empirical support for the existence of the dual role dilemma faced by central banks in reserve-constrained economies, the thesis then proceeds to examine its monetary policy implications from both a theoretical and empirical perspectives. Theoretically, an innovative model is developed that integrates the reserve management objective function (which captures both the liquidity and portfolio management roles) into a monetary policy rule. This model is tested empirically in macro panel econometric approaches using database on 13 Sub-Saharan African countries over the period 2000-2019. This empirical analysis controls for the effects of climatic vulnerability, exchange rate volatility and external forces. The main result from the empirical estimation shows that the presence of the dual role dilemma, reinforced by extreme climatic and external vulnerability exerts severe constraints for monetary policy operations. Overall, this thesis makes important contributions to the literature of reserve management and monetary policy in developing countries. In contrast to the existing academic literature, which only considers the custodial mandate of central banking management function, this thesis shows that central banks in reserve-constrained economies are forced to accept both the custodial and portfolio management roles as integral parts of their functions. In this dual mandate, central banks engage in portfolio decisions in an effort to balance liquidity and return objectives required for the growth and preservation of reserves capital to enable their reserve-constrained economies meet the ever-growing external obligations. The thesis further shows that this dual role dilemma, which is located in the deep hierarchies in the world’s international monetary system and its productive structure, reinforced by climatic vulnerability creates serious constraints for monetary policy. This thesis concludes by considering several policy conclusions that help to address the reserve scarcity dilemma, including the following. First, productivity-enhancing strategies that permit reserve-constrained economies to climb up the hierarchy of the global productive structure. Second, reducing dependence on the US dollars or currency at the center of the international monetary system. Third, designing a coherent and stable macroeconomic policy including appropriate monetary policy designs and exchange rate policies rooted in the structural subordinated position of SSA at the bottom of the hierarchies in the world’s international monetary system and its productive structure. Fourth, improvement in institutional arrangements surrounding external debt accumulation and its management, mainly by fiscal authorities, including eliminating corruption and lack of transparency and accountability in fiscal policy. Finally, coherent national strategies for combating climate change must be taken into consideration by both monetary and fiscal policy for Sub Saharan African (SSA) countries.