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A man counts his money at a money exchange counter in Colombo – Reuters
By P. Samarasiri
While noting the technical response given by Ajith Nivard Cabraal, former Governor, Central Bank (CB), to Daily FT on 8 October, in respect of the CB’s allegations made at its press briefing held on 2 October that the use of the foreign reserve in 2011/12 and 2015 was a waste as the depreciation was even greater than that at present without eating reserves. Allegations were also made on the monetary policy of celling on credit growth implemented in 2012. Same top staff who are around the present Governor were around the past Governors too for implement those policies and hope that they would not let down the present Governor later for what is being done now as usual.
Those policies were implemented with due discretion in terms of relevant provisions of the Monetary Law Act (MLA), given macroeconomic circumstances and views of the Governors, Monetary Board and relevant staff at those times and, therefore, making allegations on those policies ex-post with same staff around the table is neither professional nor technically incompetent. Macroeconomic charts and series of numbers can be presented to make any feel-good arguments to confuse public as nobody has done empirical research to establish underlying macroeconomic relationships.
Legal provisions also can be interpreted to suit macroeconomic views of current policy-makers as law-makers in the past have not defined macroeconomic concepts such as economic and price stability, financial system stability, international stability of the currency, underlying trends of the country, adequacy of reserves and many more to ensure the independence of the policy-makers as those involve in diverse economics. If the CB now wishes to let the market forces do all these, we do not need a CB. We can probably go back to the Currency Board system or old private central banks.
Those who are authorised to take policies need to understand national problems in that context and make determinations and implement policies rather than trying to interpret laws and economic concepts to cover-up their lapses or other personal ad-hoc views. We know that enormous exchange rate tensions arose in the past and were resolved by the CB without letting them to become public outcry, given the fragile nature of the economy. Such literature is amply available. However, such sprit is not seen now in view of diverse views given by the CB spokesmen and other authorities from time to time on this subject. It is also seen that the authorities are reluctant to accept that there is a national issue around the current rates of currency depreciation while blaming the US although whole world is trying their best to survive at the respective value chains in present global economies
The current circumstances are connected with global tensions of speedier, but well communicated, tightening of the US monetary policy, large-scale capital outflows, rising oil prices and global trade wars among the advanced economies where emerging market economies (EMs) are taking policy actions within their purview to survive of adverse spillover effects, primarily excessive currency depreciation, capital outflow and resulting high inflation.
Although economists are two-handed, above allegations show their additional hands to blame past policy-makers to cover-up present difficulties.
As Cabraal partly covered a technical response to the allegation on the use of foreign reserve in 2011/2012, I wish to provide a short response to other allegations and views expressed by the CB in its monetary policy press release and press-briefing on 2 October. In both, the CB makes personal statements without the support of the professional economic research on key points/specific subjects carried out in terms of sections 25 and 26 of the MLA, other than certain ad-hoc internal statistics.
Response to the Monetary Policy press release on 2 October
This press release is nothing but twisted words to satisfy those who drafted the press release as responded below. Hope that the press release was read and understood by the Monetary Board.
in terms of real interest rates which are well above some peer EMs
The CB or any central bank does not conduct the monetary policy based on real interest rates. If they do so, they must target and announce real interest rates. If real interest rates are high, capital should not outflow causing exchange rate-overshooting. The real interest rate should be estimated as current interest rates less expected inflation. In this regard, the CB’s inflation target of 4-6% based on weather and domestic food driven price index is highly inappropriate as the CB does not have any data or research to prove that the future inflation will be the CB’s target. If inflation targets are flexible which do not have any track-record, nobody knows what will be the inflation targets in future when unexpected stuffs happen in the economy. The figures relating to the stated peer countries are not given. Further, the monetary policy cannot target real variables. In this statement, the CB implicitly accepts the need for monetary tightening as in other countries to address the currency tensions because it is a monetary phenomenon.
The CB in its press release issued on 5 March 2018 on the heels of currency tensions stated that an increase in market interest rate was not expected in the near term as recent movements in headline inflation, core inflation, inflation expectations, broad money growth, credit expansion, expansion in economic activity as well as the international reserve position did not justify the view that a rational market would also expect an increase in interest rates. In contrast, now in 10 months later, the CB states increases in market interest rates after the CB cutting interest rates by 0.25% on 3 April 2018 (less than in a month from above statement). The reasons for the tight liquidity in contrast to the CB’s projection in March are not given as much as the CB reasoned out the non-possibility of interest rates rise. Since the near term was not defined earlier, the CB now can state that the near term is shorter than 8 months.
Everybody knows that the tight money market liquidity is due to liquidity-drain created by the outflow of foreign capital/currency. Accordingly, prevailing high demand for liquidity pushes up market interest rates in opposite to the current monetary policy. Therefore, the CB has to print money to keep overnight inter-bank interest rates within the policy corridor. That will push up domestic inflation, demand for more imports and worsen the BOP.
The balance sheet of the CB as at end of 2017 constituted 83% foreign currency assets. Consequent to outflow of foreign currency eventually from the CB’s reserve, the CB has to print money through local assets to keep the monetary conditions stable. This is not sustainable, given the nature of the imports and foreign borrowing-dominant open economy.
in the second quarter and deceleration in inflation
This is the main argument to keep the policy interest rates unchanged, despite almost all EMs are raising interest rates to address capital outflow and inflationary pressures arising from excessive currency depreciation, given the outlook of further tightening of the US monetary policy towards 2019/20, rising oil prices and world trade tensions. Therefore, everybody expects higher inflation. EMs tighten the monetary policy in that context as monetary policy is a futuristic policy to anchor inflation expectations in central banks’ jargon.
However, the CB looks at the past growth and CPI-based inflation to drive the monetary policy. The inflation estimated from the weather and domestic food driven CPI is not realistic to drive a macroeconomic policy like the monetary policy as it does not have a macroeconomic story other than ad-hoc price changes from time to time. Therefore, the CB states that inflation is likely to taper further on the back of decelerating food prices and favourable base effect during the remaining period of the year. The base effect is a statistical matter and not an economic factor to analyse inflation to decide the monetary policy. I recall that the Monetary Board several times advised the staff not to use the base effect to explain inflation.
Although the CB states that, with appropriate policy adjustments, inflation is expected to remain within the “4-6% target range over the medium term” it does not indicate possible risks to inflation that require appropriate policy adjustments (the CB does not use any policy adjustments other than overnight policy interest rates) and how long the medium term is to enable the public to monitor the CB’s performance.
In such situations of macroeconomic tensions that everybody expects the CB complains world-wide, the CB should consider broader indicators of future macroeconomic vulnerabilities than the past GDP growth and CPI inflation to decide the monetary policy in terms of the specific provisions of the MLA.
The CB aggressively tightened the monetary policy in 2016 along with the macroprudential loan-to-value ratio for loans to finance vehicle purchases to address rising trade deficit, despite the low growth and low inflation. The increase in reserve requirement (SRR) by 1.5% in January, an increase in policy rates by 0.5% in February without waiting for the transmission of the SRR increase and a further increase in policy rates by 0.5% in July disrupted the money and government securities markets in 2016. However, all macroeconomic issues have remained.
nExpected to ease the excessive demand for foreign currency and hence the pressure in the domestic foreign exchange market as already observed in the stabilising exchange rate
The exchange rate has not stabilised and its depreciation has increased to 12.7%, because few restrictions imposed do not improve the net inflow of foreign currency in the BOP structure. The depreciation indicated in the press release was 9.7%. The high buy-sell margin of four rupees (168.47-172.35) (indicative rates at the CB website on 9.10.2018) is a cost to sellers of foreign currency to banks.
Response to the press briefing on 2 October
If so, exchange rates that permitted by the CB so far have not been competitive as the exports and BOP problems remained. Then, the Monetary Board has violated the MLA by not maintaining the international stability of the currency competitively consistent with underlying trends in the country (see sections 63(2), 65, 66-68, 76 (1) and 77(1) of the MLA). This appears to be a new domestic economy approach of the CB spoken in general economics studied in GCE OL/AL as a scapegoat for the excessive currency depreciation as it does not like or does not have the know-how to tackle at present.
A CB spokesman expressed the benefits of consumption of local butter and fruits in place of imported butter and fruits without knowing how many Sri Lankan households can afford to consume them and how much foreign saving can contribute to fix the present currency problem. In policy economics, the CB needs to study whether the economy would respond to present rate of competitive currency depreciation to improve the BOP before making such statements. The Elasticity Approach/Marshall-Lerner Condition, J-Curve phenomenon and Absorption Approach are some of economics that the CB can research and justify its new currency policy to the public in the interest of domestic economy. However, the currency has depreciated throughout the past and no fundamental improvement in the current account or the BOP has been recorded from the domestic economy.
This was the alternative monetary policy implemented in 2012 (first time after long-time) to address high credit growth (34% in 2011) and rising trade deficit. The routine monetary policy is the increase in overnight policy rates whose effects take long lags depending on the interest sensitivity/elasticity of credit which is not known. Government credit in any way will not respond although it is expected to have a blanket effect on credit and spending. Therefore, the credit ceiling as usual produced faster results. It is accepted that selective credit ceilings are not implementable due to compliance monitoring problems and not in line with modern market-based monetary policy approaches.
Further, policy interest rates also were increased by 0.75% since February 2012 and started cutting back since December 2012 to October 2013 and remained at record low (corridor of 6.50-8.50) until March 2015 and further reduction by 0.50% in April 2015 which remained until February 2016. In addition, several other supportive policies inclusive petroleum price hike were implemented. The CB may note that a state-of-the-art policy package was implemented including interest rates hikes by 11% (policy rates corridor of 20% to 23%, the record highest) to defuse currency tensions in 2000/01. In 2008/09 too, foreign reserve was significantly used along with several interim foreign exchange restrictions to address currency tensions. Therefore, allegation in that form is technically not warranted.
These circumstances are different and not comparable. The use of the reserve was within the law. In many times, decisions to use the reserve and CB’s buying and selling exchange rates were taken by the respective staff and only ratification was done after the deals. Therefore, if the past defences were not appropriate, the same staff sitting around the present Governor also are responsible. It is noted that the outflow of government securities was $ 1.1 b in 2015 as against the inflow of $ 1.1 b in 2011-12 and $ 493 m in 2013 which may justify both instances at those underlying circumstances, if argued. As the 83% of the CB balance sheet (2017) is the foreign currency raised from the economy, the CB cannot talk about prudent reserve management by defaulting redemption/repayment of foreign currency back to the economy when demanded which will end up in a currency and monetary crisis. We cannot discard that those catastrophes will not happen if we understand the bottom of the monetary system in the country and the country’s economic and geo-political environment objectively in line with past experiences of several other countries well known.
The CB in his press release on 16 May 2018 stated that reserve was $ 9.1 b at that time. If so, the reserve in fact has decline by $ 1.8 bn. which is the total foreign currency outflow (net)/intervention (net) from the CB for all purposes to the economy. Further, how the projected $ 8.3 b towards the end of the year is arrived is not known. In May also, the CB stated that the reserve was projected to increase to $ 11 b by mid-June to clam-down the market tensions. However, the reserve stood at only $ 9.3 b by end of June. Therefore, the ad-hoc number-crunching of the CB is not credible. The CB also may consider releasing changes in the reserve in the format the Reserve Bank of India publishes in its website to enable the public to understand the movement of this magic number on which the whole country depends.
As in the past, this is the CB’s comfort to the foreign reserve and currency defence without using the monetary policy. In terms of the MLS, national monetary policy covers the maintenance of the international stability of the currency for the BOP. However, the CB uses debt manager function to perform the monetary policy for this purpose. Such market borrowings that were arranged annually by the CB to build the foreign reserve are a major source of foreign debt trap of the country. Therefore, keeping the monetary policy dormant by resorting to comforts of the government’s foreign borrowings could be a violation of the MLA.
The fiscal slippage in terms of budget deficit and debt has been a structural problem throughout the past. The CB is the debt manager and financial adviser to the government. There is no evidence to state that there is no fiscal slippage now. In 2017, budget deficit stood at high 5.5% of GDP and public debt at 77% of GDP where these numbers are highly controversial. There is no magical fiscal improvement to reduce its slippage by now in 10 months of the year or in the future, given the socio-economic profile of the fiscal front of the country. If there is no fiscal slippage, why does the CB arrange $ 2.5 b foreign market borrowings further this year? Therefore, these could be politically-biased statements as usual.
Comparison of country economies in this manner is not in good macroeconomics. Those countries also have been hit hard despite all those. Interest rates and other macro variables cannot be compared in absolute terms to express microeconomic stories as country economies have diverse economic and social fundamentals. In same token, the CB can state that US interest rates, real interest rates, economic growth are lower than ours and, therefore, we are still better off and nothing to worry. Almost all central banks are tightening the monetary policies and, therefore, they all should be mad. What is necessary here is to maintain whatever the prevailing relative/competitive position in response to others and move in competition. If this position is not accepted by quoting absolute numbers, the only option available to the CB is wait and see anything happen anything to the economy and pass the blame to the public or government on their lapses and risk-taking because the CB will not collapse as it is the money printing press.
The fact of the matter is investment outflow in this year that contributed to currency tensions. Whether there was investment inflow higher or lower in the past has no relevance. Such stuffs happen beyond our control, but we have to act to resolve them without waiting to die.
The CB also stated that it can professionally handle the country’s current exchange rate issue and debt situation. However, as the media reports on 5 September 2018, it appears that the Government has taken over the subject through the National Economic Council, despite it is the public duty of the CB under the MLA and Foreign Exchange Act. There is nothing wrong in the government taking over it as the currency is a liability of the government issued by the CB on behalf of the government under the MLA. The debt situation, despite that the CB has been the debt manager since 1950, cannot be resolved in our generation if the CB continues to use the debt manager function to conduct the monetary policy to manage exchange rate, interest rates and market liquidity.
The CB should not take present currency tensions lightly with happy smiles/gestures because such tensions could be early warnings of excessive concentrations already burning under ashes that could cause currency crises and macroeconomic disruptions, given always fragile financial systems with 83% of the CB’s balance sheet in foreign currency assets and current regional and global links/issues that will not be settled in the near future through the market mechanism with flexible exchange rates and inflation targets as the Europe also is now ready to tighten the monetary policy beginning next year to accompany the US. Then whole world will get into the tightening monetary cycle soon as those are global reserve currency countries. The CB has the policy discretion, but it does not have the discretion to let the economy bankrupt by not being consistent with the global economic trends. Therefore, as in other central banks, it is advisable that one CB spokesman addresses the public and declares its policy discretion firmly so that the public can decide their stance in proper market mechanism before catastrophes happening unlike in all the past economic and financial crises in many countries.
(The writer is a recently retired public servant as a Deputy Governor of the Central Bank supervising the financial sector and a chairman and a member of several Public Boards. He also served as the Director of Bank Supervision and the Secretary to the Monetary Board in the Central Bank. He has authored several economics and financial books and articles covering this topic)
