Central Bank continues MMT-styled money printing despite monetary policy tightening

The Central Bank of Sri Lanka (CBSL) has adopted a tight monetary policy stance since early this year by raising its policy interest rates for arresting the money supply growth which caused severe inflationary pressures and external imbalance. Today, the year-on-year inflation is over 70% while the deficit in the current account of the balance of payments exceeds 4% of GDP. The depletion of the country’s foreign reserves to near-zero levels since last year has led to a depreciation of the rupee by 85% over the last 12 months. 

The present tight monetary policy is said to be a reversal of the previous accommodative monetary policy stance based on the so-called Modern Monetary Theory (MMT). However, the CBSL still seems to be 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, has become futile in containing the money supply growth. 

Unless drastic fiscal reforms are taken place, the budget deficit will remain high in the range of 12-15% of GDP compelling the CBSL to continue lending to the Government, and hence, economic instability is likely to worsen in the coming months.

CBSL’s lending to Govt. rising

The CBSL accommodates fiscal deficits by purchasing Treasury bills and bonds and providing temporary advances to the Government. Such lending ends up as Net Credit to the Government (NCG) on the asset side of CBSL’s balance sheet. This causes a rise in the monetary base or reserve money exerting multiplier effects on the aggregate money supply and the overall liquidity level of the economy.

The CBSL’s lending to the Government has increased at a rapid pace since early 2020. As a result, its holdings of Government securities rose by as much as 3,347% from Rs. 70 billion in January 2020 to Rs. 2,413 billion by now. This led to an increase in currency (notes and coins) in circulation by 62% from Rs. 668 billion in January 2020 to Rs. 1,080 billion in August 2022. 

The broad money supply, which consists of currency, demand deposits, and time and savings deposits rose by 56% from Rs. 7,704 billion in January 2020 to Rs. 11,987 billion in August 2022. Such rapid money supply growth emanating from deficit financing is largely responsible for the present hyperinflation and balance of payments deficit.

CBSL – a blind follower of MMT

The idea of MMT – an awkward policy prescription for funding government spending – was developed by a few academics in the US and Australia who broke away from mainstream economics. They assert that a sovereign government can print unlimited amounts of money to repay its debt without causing any financial or economic repercussions. Thus, a government can never run out of cash, as it can repay its debts without any limit by directing the country’s central bank to print new money, instead of resorting to taxation for revenue mobilisation. 

MMT has recently gained attention in a few countries due to the increased government response to the COVID-19 crisis. In 2020, for example, the central banks in Canada and the US bought large amounts of government bonds implying that they are more or less practicing MMT.

In Sri Lanka, MMT was heavily used by the CBSL authorities a few months back to justify its increased lending to the Government. They pointed out that since the rupee-denominated Government securities are within the ‘sovereign powers’, money could be printed to repay the debt, as advocated in MMT. Ignoring the basic principles of Economics, the top officials of CBSL had the audacity to contend that money supply growth does not cause inflation. 

Following the unfounded arguments of MMT, the CBSL conveniently used money printing as a straightforward way to provide lending to the Government. It has led to raising the country’s money supply at a rapid pace jacking up consumer prices to reach hyperinflation levels and causing severe macroeconomic imbalances, as repeatedly predicted in this column two years ago. 

Monetary policy tightening

Deviating from the low-interest rate policy stance adopted in early 2019, the CBSL doubled the policy interest rates in April 2022. Accordingly, the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) were raised by 700 basis points to 13.50% and 14.50%, respectively. Even before this policy announcement, market interest rates were on the rise due to heavy Government borrowings. Hence, the CBSL was compelled to give up its rigid low-interest rate policy stance. The rates were further raised by 100 basis points in July 2022, and since then, the SDFR and SLFR have remained high at 14.50% and 15.50%, respectively. 

The CBSL’s immediate objective of the policy rate hike was to fix the brakes and stop the economy from crashing. However, it is doubtful whether the economic downfall could be arrested merely by raising interest rates as the whopping fiscal imbalance is bound to deactivate those brakes, as I stressed in a previous column in this series (https://www.ft.lk/columns/Economic-mess-looms-with-interest-rate-shock-and-debt-default/4-733537). 

MMT practices continuing

The monetary policy still seems to be based on MMT, although the CBSL opines otherwise. This is reflected in CBSL’s relentless lending to the Government causing a continuous rise in money supply growth. Such lending nullifies the very purpose of the tight monetary policy stance in operation at present. 

Since the adoption of the tight monetary policy in April 2022, CBSL’s holdings of Government securities rose by 30 % from Rs. 1,853 billion to Rs. 2,413 billion now. Reflecting the increase in NCG resulting from CBSL’s lending to the Government, the outstanding stock of reserve money rose by 7% on a year-on-year basis during the 12 months ending August 2022 causing a 14% increase in the broad money supply. 

If not for the decline in CBSL’s net foreign assets to near-zero levels due to the current foreign exchange crisis, reserve money would have risen faster causing a much bigger increase in the money supply. 

Domestic debt market unsustainable

As foreign borrowings dried up due to the foreign debt default announced last April, the entire burden of financing the budget deficit falls on the domestic debt market, which is not big enough to meet the huge financing requirements of the Government. Hence, the CBSL is compelled to further extend credit to the Government to fill the financing gap.

The situation has become far worse with the increase in the Treasury bill issuing limit by Rs. 1,000 billion from Rs. 3,000 billion to Rs. 4,000 billion in June 2022. 

The Government securities market, particularly the Treasury bill market, is under tremendous pressure as reflected in sharp yield rate hikes and substantial under-subscription at successive weekly auctions. At the most recent auction held last week, only Rs. 16.1 billion of Treasury bills were sold accounting for 21% of the offered amount of Rs. 75 billion. The weighted average yield rate remained high at 33.05% for 91-day Treasury bills, 32.53% for 182-day bills, and 29.60% for 364-day bills. 

As in the past, the unsold Treasury bills are to be purchased by the CBSL, thus, further pushing up its NCG and in turn, the reserve money stock and the money supply, as explained above. Meanwhile, the Government has to bear an additional interest payment cost to the tune of around Rs. 1 trillion per year as a result of the Treasury bill yield rate hike. This will aggravate the debt crisis further, and hence, the worst is yet to come. 

Monetary policy inactive 

The CBSL authorities themselves have deactivated their monetary policy instruments by timidly accommodating the fiscal demands due to political pressures. In the circumstances, the CBSL has practically lost its key monetary policy instrument – Open Market Operations (OMO) – which can be used to absorb any excess liquidity in the market by selling Government securities and vice versa. 

OMO could have been effectively used in today’s context by selling securities to reduce excess market liquidity for mitigating inflationary pressures. The CBSL is unable to do so, as it continuously buys securities, mainly Treasury bills, to bridge the budgetary shortfalls, as elaborated in this analysis. Thus, OMO has become a one-way operation, i.e. continuous purchasing of securities by CBSL. 

The present tight monetary policy, therefore, is confined to the interest rate hike which fails to reduce market liquidity, as the CBSL pumps liquidity into the market by purchasing Treasury bills week after week. 

The capacity of the CBSL authorities to reactivate monetary policy for economic stabilisation purposes depends on their strength to diffuse political pressures that urge money printing for fiscal purposes. 

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