The International Monetary Fund (IMF) has urged the implementation of gradual reforms aimed at strengthening the independence of central banks across the Middle East, North Africa, and Central Asia regions. These reforms include a comprehensive review of central banking laws,
affirming price stability as a primary objective, and defining clear and effective mandates for formulating and executing monetary policy. A report released by the Fund on Tuesday highlighted the urgent need to establish stringent rules that prohibit or limit government financing
through central banks. Specifically, this includes banning direct purchases of government debt instruments or providing open-ended loans to the treasury, thereby preventing central banks from becoming a financing arm for the executive authority during periods of escalating financial pressure. The report
also underscored the importance of enhancing the financial autonomy of central banking institutions by empowering them to approve their own budgets. It further emphasized the necessity of setting clear guidelines for profit distribution, covering potential losses, and recapitalization, which would
bolster their capacity to fulfill their core functions unhindered by short-term government fiscal demands. The proposed reforms encompass: * Improving governance mechanisms through the selection of governors and board members based on professional competence and experience. * Adopting staggered
and longer terms of office that extend beyond political cycles. * Reducing the participation of government representatives on central bank boards, aimed at mitigating conflicts of interest and strengthening the independent oversight role of these banks. The Fund also recommends
publishing monetary policy reports, audited financial statements, and meeting minutes whenever feasible. It called for explaining decisions taken to the public and investors, asserting that a central bank's credibility rests not solely on its independence but also on its accountability
and ability to clarify its objectives and choices. The IMF report concluded that the independence enjoyed by central banks is directly linked to an enhanced ability to curb inflation and contain price shocks. This correlation is particularly evident in countries that
adopt clear monetary policy frameworks and grant their central banking institutions broad powers, free from any immediate political or financial pressures. The report highlights the significance of central bank independence at a time when several nations face concurrent challenges, including rising
debt costs, increasing government financing needs, sharp fluctuations in food and energy prices, and the weakening of local currencies in some commodity-importing economies. According to the document, the average inflation in countries of the Middle East and Central Asia significantly declined
from approximately 9% between 1981 and 1999 to 5% in the subsequent period leading up to 2019. This reduction coincided with a gradual improvement in the level of central bank independence, particularly since the turn of the millennium. The Fund clarifies
that this progress has not been uniform across all countries. Nations with pegged currencies, including the majority of Gulf states, achieved better results in price stability due to the presence of a defined nominal anchor. Conversely, countries lacking clear monetary
frameworks or those subject to what the report describes as "fiscal dominance" faced greater difficulties in controlling inflation. The concept of "fiscal dominance" focuses on pressures that drive a central bank to finance the government or maintain interest rates at levels
that do not reflect the actual need to curb inflation. These pressures have become evident in economies suffering from high domestic debt, chronic fiscal deficits, or a broad reliance on subsidy programs and administered prices. **Inflation Test** According to the report, the
wave of inflation that followed the COVID-19 pandemic constituted a real test for the independence of central banks in the region. Global prices surged due to supply chain disruptions and rising food and energy costs, with these pressures intensifying after
the Russia-Ukraine conflict. This forced central banks to balance efforts to curb inflation with supporting economic recovery. The Fund indicates that countries with a clearer mandate for price stability and more transparent monetary frameworks managed the inflation wave more effectively. In
nations with pegged exchange rates, the credibility derived from the peg helped anchor inflation expectations, especially when supported by ample foreign reserves and the capacity to absorb economic shocks. Conversely, countries adopting different monetary frameworks experienced a subsequent decline in inflation
rates, yet these remained higher than pre-pandemic levels in several instances. This is attributed to the weak transmission of monetary policy effects to the economy, increased dollarization, diminished effectiveness of capital markets, and governments' reliance on local banks for their
financing needs. The report presents Lebanon as an example of severe economic deterioration, accompanied by "erosion of confidence in monetary and fiscal policy," as described. The economic and financial crisis there resulted in hyperinflation, a rapid depreciation of the national currency,
and a depletion of foreign exchange reserves, following years of unsustainable fiscal and monetary policies. Regarding Egypt, the report pointed out that rising domestic debt, persistent pressure on the local currency, and the subsequent withdrawal of some subsidy measures contributed to
weakening the effectiveness of monetary policy transmission and increasing inflation rates. This occurred despite the enactment of a new law for the Central Bank and the banking sector in 2020, which aimed to modernize the legislative framework and enhance the
supervisory role. **Reform Models** The report documents progress achieved in several Arab countries. Morocco and Algeria, from the 1980s until 2010, implemented legal and institutional reforms centered on price stability, strengthening the personal and financial independence of their central banking institutions, and
imposing strict limits on deficit financing. Jordan demonstrated progress in legal independence, particularly after the 2008 global financial crisis, by enhancing restrictions on direct government lending. Meanwhile, Iraq enacted reforms that raised the degree of its central bank's independence as part
of a broader trajectory to build its monetary institutions after a long period of instability. In Tunisia, a new central bank law was adopted in 2016, bolstering its role in formulating monetary policy. In Saudi Arabia, the Central Bank was granted
broader powers to regulate the financial sector and achieve its objectives under a system issued in 2020, with ongoing efforts to enhance its operational independence, accountability, transparency, and legal protection. However, the Fund does not consider legal independence alone sufficient; the
distinction between the legal text and actual practice remains a crucial factor. A central bank might possess statutory independence but may, in reality, face political or financial pressures that limit its ability to raise interest rates or tighten credit when
inflationary conditions necessitate such actions. According to the report, the impact of central bank independence reforms takes time to fully manifest. The analytical models used indicate that an increase in the independence index correlates with a reduction in inflation by approximately
0.5 to 0.6 percentage points after one year, with this effect peaking in the fourth year, where inflation remains about 0.5 to 0.8 percentage points lower compared to the baseline trajectory. **Arabian Gap** The Fund observes that countries in the region have
made "significant" strides in bolstering the legal independence of their central banks, especially in the areas of financial autonomy, disclosure, and reporting. Nevertheless, the report points to the continued existence of institutional weaknesses that affect these banks' ability to act
with full independence when confronting sudden price shocks. As per the report, the most pronounced gap is evident in central bank governance, specifically in the mechanisms for appointing governors and board members, the duration of their terms, and the potential for
appointment or dismissal decisions to be influenced by the executive authority. Overall, countries in the Middle East, North Africa, and the Gulf region still lag behind advanced economies in the level of independence of their central bank boards and governors, as
stated in the report. The report also highlights the issue of government lending. The Fund explains that allowing central banks to finance the public sector, or the absence of clear legal constraints on such financing, could conflate the objective of price
stability with the needs of the public treasury, thereby reducing the effectiveness of monetary policy. The report notes a significant disparity among Arab countries in the region. While Gulf states have generally maintained low and stable inflation rates, supported by their
currencies' peg to the US dollar and their possession of substantial fiscal buffers and reserves, other nations such as Egypt, Lebanon, and Tunisia have faced greater pressures. This is attributed to the interplay of external shocks with internal imbalances related
to public finance and exchange rates. The report mentions that the Gulf Cooperation Council (GCC) countries began strengthening the legal independence of their central banking institutions since the late last decade, alongside developing regulatory and financial frameworks as part of their
economic diversification efforts. However, it cautions that some restrictions related to government lending and the multi-faceted mandates of central banks still require clearer legal regulation.
