Central Bank already an independent authority since inception by law, but not in practice

• Speech delivered at a recent seminar co-hosted by the Sri Lanka Economic Association and the Economic Students’ Association, University of Colombo

The Ministry of Finance gazetted the new Central Bank of Sri Lanka Bill last month which is to be tabled in Parliament shortly repealing the Monetary Law Act (MLA) of 1949. The new legislation is expected to bolster the Central Bank’s independence and transparency based on an inflation-targeting monetary policy framework aimed at price stability.

Independent central banking is not something new to Sri Lanka. The MLA provided a sufficient degree of independence to the Central Bank to conduct monetary and financial management. But the Central Bank could not exercise the given independence due to its failure to resist political pressures, particularly during the last three decades.

The new bill is a precondition to be fulfilled under the envisaged Extended Fund Facility (EFF) arrangement with the International Monetary Fund (IMF) to stop Central Bank’s lending to the Government. Even without such a new law, the Central Bank has adequate space given under the MLA to conduct monetary policy independently of the Government.

As the Bank has not exercised its autonomy to achieve price stability, further legislation has become imperative, although some critics argue that the new bill is a conspiracy against the country’s democracy masterminded by the IMF and the Western world.

Central bank independence is not new to SL

Independent central banking embedded in the new bill is widely publicised as a brand-new phenomenon introduced in Sri Lanka, which is not the case, as it was a prime concern of John Exter – the architect of the MLA.

In his report on the establishment of the Central Bank of Ceylon presented to Parliament in 1949, Exter stated, “The decision of the Government of Ceylon to establish a central bank was a decision with far-reaching implications for the people of Ceylon. One implication already stands out very clearly; in taking steps to establish an independent monetary system to be administered by a central bank, the Government has demonstrated unmistakably its intention to achieve genuine economic freedom as a corollary of the political freedom achieved a year and a half ago.”

He further stated, “Under the draft law, the Central Bank will be the principal monetary authority, but it is obvious that it cannot exercise its authority in the monetary field as in a water-tight compartment from which the various ministries and other agencies of the Government are excluded. … But it is the clear intent of the Bill to concentrate, in so far it is considered practicable and constitutional to do, as much monetary authority and responsibility as possible in a single regulatory and operating agency – the Central Bank.”

At the second reading of the Monetary Law Bill in Parliament in 1949, the then Minister of Finance J.R. Jayawardena emphasised, “It is very difficult to say that the Central Bank should be entirely a department of the Government or subservient to the Government. We have tried as far as we could, in this Act to make the Central Bank, or at least the Monetary Board, independent as far as its advice is concerned.”

Why central bank independence matters

One could raise the question of why should not the Central Bank be under the direct control of the Government like any other state-owned entity – say, the Water Board, Ceylon Electricity Board, or Sri Lanka Telecom. What is so special about the Central Bank?

The answer lies in the supreme power that the Central Bank holds which other government entities do not have – that is, its unique power to issue notes and coins, which are called currency. This currency-issuing process is commonly known as money printing. Currency, identified as narrow money, is a part of the country’s broad money supply which includes savings and fixed deposits of commercial banks.

When the Central Bank lends to the Government to finance the budget deficit, it purchases Treasury bills and bonds. The Central Bank also provides temporary advances to the Government. Such lending ends up as Net Credit to the Government (NCG) on the asset side of the Central Bank’s balance sheet. This causes a rise in the Central Bank’s monetary base or reserve money exerting multiplier effects on the aggregate money supply and the overall liquidity level of the economy.

The idea of having Central Bank independence is to prohibit its lending to the Government by directly purchasing Treasury bills and bonds from the primary market.

The alternative view is that the central bank should be under the direct control of the government since the central bank should respond to the will of the people in a democratic society. In practice, however, central banks operate between these two extreme paradigms and enjoy different degrees of independence in each country.

Time inconsistency problem

In general, the political authorities are considered to have a short-term time horizon in policymaking as they have to satisfy the voters within a short period by providing jobs and various welfare facilities through borrowings. In the short run, such spending brings about benefits such as employment creation and output growth. But spending in such a lavish manner tends to accelerate inflation in the long run due to money supply growth resulting from government borrowings from the banking sector, particularly from the central bank.

This tendency, known as the time inconsistency problem in monetary theory, is a major justification for having independent central banking.

Types of CB independence

There are two types of central bank independence – goal independence, and instrument independence. It is generally accepted that the goals of monetary policy should be left to be decided by the government, as the elected political authorities are accountable to the electorate. The instrument independence, which refers to the ability to freely adjust the policy tools to achieve goals, is usually given to the central bank, as in the case of the MLA.

The term ‘independent’ is misleading

Independence does not mean that a central bank can do whatever it likes, ignoring the policies of the elected government. What it means is that the central bank should adopt ruled-based policies targeting its mandated goal of price stability, instead of applying discretionary policies bowing down to political masters.

In an essay published in 1962 titled ‘Should there be an Independent Monetary Authority?’, Milton Friedman, the found of monetarism, rejects the two extreme ideas of a completely regulated central bank and a fully independent central bank. Friedman preferred legislation that specifies the rules for the conduct of monetary policy and restricts the central bank’s discretion. The rules are subject to public control through the legislative process and insulate monetary policy from the whims of politicians.

Legal or de jure central bank independence is necessary, but not sufficient, because the law in actual practice or de facto independence may be quite different, as evident from the Central Bank’s failure to exercise the policy space given in the MLA since its inception. The need for a new Act would not have arisen, had the Central Bank conducted its monetary policy strictly in accordance with the MLA

Monetary policy rules vs. Discretion

The superiority of rules vis-à-vis discretion has been a central theme of monetary policy literature over the last three decades. The most common measurement that has been used to evaluate monetary policy is the rule developed by J.B. Taylor in 1993. The Taylor rule prescribes that a central bank should systematically adjust the policy interest rates in response to changes in inflation and macroeconomic activity.

According to our estimates, the actual policy interest rates have widely deviated from the Taylor-based interest rates over the last three decades implying that the Central Bank has applied discretionary monetary policy, instead of rule-based monetary policy.

Discretionary monetary policy through MMT

The monetary policy adopted by the Central Bank since late 2019 is a classic example of discretionary monetary policy. The Government accumulated a sizeable amount of domestic and foreign debt used for various politically-motivated infrastructure projects that did not generate sufficient tax revenue or foreign exchange earnings. The servicing of debt became an enormous burden to the Government, in addition to financing its huge day-to-day expenses.

In such circumstances, the Central Bank discovered a magical way to bridge the budget deficit. That was the silly Modern Monetary Theory (MMT). The then Governor of the Central Bank argued that domestic currency debt is not a huge problem for a country with sovereign powers of money printing as prescribed in MMT.

Accordingly, the Central Bank generously lent to the Government and as a result, the money supply accelerated causing inflationary pressures. Meanwhile, the Central Bank kept its policy interest rates at a very low level and maintained a fixed overvalued exchange rate. This led to an outflow of foreign exchange from the country. This is the phenomenon of the ‘Impossible Trinity’ or ‘Policy Trilemma’ that I reiterated in the previous FT columns.

The present tight monetary policy is claimed to be a reversal of the previous accommodative monetary policy stance based on the so-called Modern Monetary Theory (MMT). However, the Central Bank is still following the same type of expansionary monetary policy, as it continues to lend to the Government by way of money printing, which is the basic premise of MMT. Consequently, the tight monetary, which is confined to the interest rate hike, at present has become futile in containing the money supply growth.

CB independence meaningless without fiscal discipline

The dominance of fiscal policy over monetary policy prevails in Sri Lanka. The Government has been increasingly dependent on the Central Bank to finance its budget deficit which hovers around 12-15% of GDP. The total tax revenue as a ratio to GDP declined over the years. The revenue mobilisation has worsened since 2020 as a result of the arbitrary tax cuts implemented in the aftermath of the Presidential election in 2019 for political reasons.

The Fiscal Management and Responsibility (FMRA) Act was enacted by Parliament in 2002 to introduce strict fiscal rules. 

The two prominent objectives stipulated in the Act were (a) to reduce the government debt to prudent levels by ensuring the budget deficit does not exceed 5 percent of GDP from the year 2006 onwards, and (b) that total government liabilities (including external debt) do not exceed 60 percent of GDP commencing 2013.

Since then, however, the fiscal authorities have failed to comply with the rules on the budget deficit and debt as stipulated in the FMRA. This was due to the rise in expenditure for infrastructure development, social welfare, salaries, debt repayments, interest payments, and transfers to loss-making state enterprises. Thus, legal (de jure) fiscal targets enforced by the FRMA Act have little meaning in actual practice (de facto).

The controversial direct tax increases proposed in the Budget 2023 are unlikely to make any improvement in the fiscal situation, as around 75% of such increased tax revenue is going to be absorbed by the increased recurrent expenditure. This means that the government will have to borrow more and more from the banking sector to finance the deficit.

One could raise the question of why should not the Central Bank be under the direct control of the Government like any other state-owned entity – say, the Water Board, Ceylon Electricity Board, or Sri Lanka Telecom. What is so special about the Central Bank? The answer lies in the supreme power that the Central Bank holds which other government entities do not have – that is, its unique power to issue notes and coins, which are called currency

Independent central banking vs. democracy

Some critics argue that central bank independence conflicts with the democratic principle that government policies should be controlled by elected parliamentary members, rather than by an elite group of officials who are insulated from the political process.

On the other hand, as mentioned earlier, there is a strong case for the independence of the central bank to ensure that it takes a long-term view and effectively conducts monetary policy.

This apparent conflict immediately raises the question of how to reconcile the two opposing views.

Such conflict is largely overcome by the accountability and transparency obligations of the new Bill under which the Central Bank is expected to operate within an inflation-targeting monetary policy framework.

The Finance Minister and the Central Bank are required to sign a monetary policy framework agreement to set out the inflation target to be achieved by the Bank. Further, the Minister is also required to publish the monetary policy framework agreement including the inflation target and other parameters relating thereto in the Gazette within one week from the date of such agreement. There are several other accountability and transparency clauses in the bill. However, these clauses are merely confined to reporting to Parliament.

Political influence continues to dilute CB independence

The terms and conditions of appointment and dismissal of the Governor and the Monetary Board are key factors that demine central bank independence. As in the case of the present MLA, the new bill gives the sole authority to the Finance Minister in appointing the Governor and the Monetary Board members in consultation with the President. When the President himself is the Finance Minister, as at present, the Finance Minister has to consult himself in making the appointments.

The timing of the bill seems problematic, given the dire need for the Government at present to borrow from the Central Bank and commercial banks to finance its sizeable budget deficit. 

The new bill requires the Central Bank to completely stop lending to the Government. If implemented, it could pose a major threat to fiscal sustainability in the backdrop of inaccessibility to foreign capital markets due to the country’s debt default. In the circumstances, the political authority might tend to overrule the new Act and pressurise the Central Bank to provide funding for budgetary purposes – a situation similar to the total negligence of the Fiscal Responsibility and Management Act.

Legal or de jure central bank independence is necessary, but not sufficient, because the law in actual practice or de facto independence may be quite different, as evident from the Central Bank’s failure to exercise the policy space given in the MLA since its inception. The need for a new Act would not have arisen, had the Central Bank conducted its monetary policy strictly in accordance with the MLA.

In John Exter’s words, “Good central banking is less good law than good practice.”

(The writer, Professor Emeritus at the Open University of Sri Lanka, is a former Central Banker.)