Central bank financing of government returned to the fore of the policy debate during the Covid-19 crisis as many countries faced additional budgetary pressures at a time when debt levels were already high. Several economists called for an expansion in quantitative easing programmes and injections of ‘helicopter money’ explicitly for fiscal purposes (Blanchard Pisany-Ferri 2020, Gali, 2020), lifting the ‘taboo’ around central bank financing of governments, at least temporarily (Yashiv 2020).
But even the advocates of monetary finance still highlight the risks, in particular ‘fiscal dominance’ and its inflationary consequences. The dangers of fiscal dominance, or the coordination scheme where fiscal policy dominates monetary policy1 (Sargent and Wallace 1981) have long been warned against by economists and policymakers and history provides no shortage of cautionary tales. Many hyperinflation episodes have been associated with central bank financing of government debt: Weimar Germany (1922–23), Hungary (1945–46), Greece (1941–45), and Latin America during the 1980s debt crisis, to name a few.
However, there has been limited empirical research on the determinants and impact of central bank financing of government deficits beyond the most extreme episodes of hyperinflation. A large literature has studied the relationship between central bank independence and inflation (Cukierman 1992, Alpanda and Honig 2014), though the results are ambiguous (Baumann et al. 2021). A few studies examine legal limitations on central bank lending to the public sector (a sub-component of de jure indices of central bank independence) and find a negative association between the strictness of limits and inflation (Jacome et al. 2012, Garriga and Rodriguez 2020). However, these studies ignore a crucial link: the relationship between legal limits and actual central bank lending to government in practice.
Evidence from sub-Saharan Africa
In recent work (Hooley et al. 2021), we look at what lessons can be drawn from sub-Saharan Africa, a region where government financing by central banks has been common, even prior to the Covid-19 crisis. Unsustainable financing of fiscal deficits financing by central banks has led to stark episodes of hyperinflation in countries such as Angola, the Democratic Republic of the Congo, and Zimbabwe. But it has also been a more generalised phenomenon. In fact, the incidence of central bank lending to government in sub-Saharan Africa has been much higher than elsewhere (Figure 1), amounting to 2% of GDP on average during 2001–17, compared with less than 0.5% in other regions. Moreover, the Covid-19 crisis led some central banks to lend large amounts to their governments as financing constraints started to bite (Democratic Republic of Congo, Ghana, Mauritius) (IMF 2020).
Figure 1 Central bank financing is highest in sub-Saharan African countries
Sources: IMF, International Financial Statistics; IMF, World Economic Outlook; and IMF staff calculations.
The role of legal limits
Because of the prevalence of central bank lending to governments in sub-Saharan Africa, the question of whether (or how much) to restrict it has long been a feature of policy debates in the region. Many countries impose legal limits on central bank lending to government (both direct and indirect), specified in their central bank legislation. The limits are typically applied to loans, overdrafts, and advances extended in any given year, defined as a percentage of fiscal revenue.2 Most limits allow for some limited budgetary financing from the central bank, usually with the aim of providing a lender-of-last-resort facility to cover intra-year fluctuations in revenue in economies where alternative market financing options may be sparse and shocks relatively frequent.
Any empirical analysis of central bank financing of government deficits in the region therefore needs to take account of these legislative constraints. We augment the IMF’s Central Bank Legislation Database for our sample of sub-Saharan African central banks to include quantitative information on legal limits on central bank lending to government, updated to 2017. This shows that many sub-Saharan African countries have introduced (and in some cases tightened) such limits over the past three decades (Figure 2). The limits are set somewhat higher in sub-Saharan African countries than in other regions, but still permit only modest and temporary central bank lending to government.
Figure 2 Legal limits in sub-Saharan Africa have become stricter over time
Sources: IMF, Central Bank Legislation Database; IMF, World Economic Outlook; national authorities; and IMF staff calculations.
Non-binding but a speed limit
But how effective are legal limits in a region where institutions are relatively weak? Interestingly, while the data show that the legal limits were frequently breached, the observed patterns of noncompliance suggest that they nevertheless have teeth. The recourse to the central bank when deficits rose was indeed lower when legal limits were in place – a result confirmed in econometric analysis. The effect of legal limits is therefore analogous to a speed limit for car drivers: the limit is often exceeded, but rarely by a lot, and drivers go more slowly than when there is a (more stringent) limit.
Other factors affecting the propensity of governments to borrow from their central bank include the prevalence of outside financing options and an IMF programme. On average, about 9% of a fiscal deficit is financed by the central bank. But if the government can borrow from financial markets and issue bonds, then only about 3% of the fiscal deficit is covered by central bank financing. And if the government has an IMF-supported programme with a condition on domestic borrowing or borrowing from the central bank (akin to a quasi-legal limit), then almost none of the deficit is covered by central bank financing.
But should we care about deficit financing, particularly if it is small and does not pose hyperinflationary risks? In short, yes, because central bank deficit financing matters for inflation. Empirical investigation of the impact of central bank lending on monetary aggregates, the exchange rate, and inflation finds a statistically significant contemporaneous impact on the exchange rate and a lagged impact on inflation. An increase in central bank credit to the government by 1 percentage point of GDP – or about 5 percentage points of revenue – is associated with a decline in the exchange rate of 1 percentage point contemporaneously and an increase in inflation by half a percentage point a year later. Moreover, the impact on inflation seems to be mostly through the exchange rate channel; there does not seem to be evidence of credit growth (the aggregate demand channel).
In summary, our findings suggest that fiscal dominance is a relevant macroeconomic risk that policymakers should take seriously – even if the impact of central bank deficit financing does not reach hyperinflation proportions, it can still generate significant inflation pressure. Although a central bank may sometimes need to provide additional financing in exceptional circumstances, for example, during the Covid-19 pandemic, it should be on a temporary basis to avoid the risk of runaway inflation and keep expectations anchored.
Authors’ note: The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.
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1 The concept of fiscal dominance used here is based on Sargent and Wallace (1981). Fiscal policy ‘dominates’ monetary policy when the fiscal authority independently sets its budgets (deficits) and determines the amount of revenue that must be raised through bond sales and seignorage; and the monetary authority faces the constraints imposed by the government as it must try to finance with seignorage any discrepancy between the revenue demanded by the fiscal authority and the amount of bonds that can be sold to the public.
2 Separating any central bank’s claims on government (on its balance sheet) into monetary and fiscal policy purposes is not straightforward in practice. Some claims are typically extended for monetary policy purposes. For example, central banks may hold treasury bills for liquidity management (for example, conducting open market operations) or to influence monetary conditions at the zero-lower bound (for example, quantitative easing - though these programs can sometimes, in theory at least, have a fiscal purpose (Cukierman, 2020)). For our sample of sub-Saharan African countries for the pre-Covid-19 period, central bank claims on government to accommodate fiscal needs were typically through loans (overdraft facilities), while direct government bond issuance to central banks for fiscal purposes or securitization of overdrafts has, to our knowledge, only occurred in a few African countries and on an exceptional basis. We therefore assume that central bank holdings of government securities are mostly for monetary policy purposes, while loans and advances to governments are for fiscal policy purposes (although we include securities holdings in robustness checks).