Central Banks are not strangers to unpopularity

The establishment of the CBSL was a proud moment in the post-independence history of Sri Lanka. The Bank, as the apex financial authority in the country, is entrusted with the mandates of maintaining economic and price stability and financial system stability

The Central Bank of Sri Lanka (CBSL) celebrates its 70th Anniversary today. The establishment of the CBSL was a proud moment in the post-independence history of Sri Lanka. The Bank, as the apex financial authority in the country, is entrusted with the mandates of maintaining economic and price stability and financial system stability. These two objectives are complementary to each other and they affect all sectors of the economy. 

Central banks worldwide were called upon to be risk managers during the Global Financial Crisis (GFC) of 2007-09, followed by the Great Recession. Quantitative Easing, which fast-tracked implementation of lender of last resort policies, and overhauling financial regulatory regimes were some of the key measures executed by central banks in response to the said crisis. While financial systems and economies were struggling to restore stability, and wipe off the scars of GFC, there came the COVID-19 pandemic, with devastating impacts on almost all sectors. Central banks have been required again to find solutions to COVID-19 induced instabilities. At this very special moment of CBSL’s 70th Anniversary, this article is dedicated to discussing challenges faced by central banks during this unprecedented crisis.

Independence of central banks at a crossroads

Literature suggests that central banks have been facing three challenges i.e. economic, intellectual and institutional. Whether central banks have ammunition to handle the next crisis while inflation remaining constantly below the target is standing as an economic challenge. The lack of a clear mechanism to push demand up when it is needed appears as an intellectual challenge. The value of central banks’ independence, which has been a topic for critics after the GFC, is the key institutional challenge faced by modern central banks.

This concept of independence of central banks should be given the foremost attention in any discussion pertaining to central banking. It remains relevant to all jurisdictions irrespective of the level of development. Institutional, financial and operational independence are highlighted as key elements of the central bank independence story. In the Gauweiler and Others v Deutscher Bundestag case, it was stated that institutional independence implies that a central bank has a “broad discretion”. Literature shows that in advanced economies, central bank independence and inflation traditionally show a significant negative correlation. Since the mandates of central banks worldwide have been stretched after the GFC, the phenomenon of independence needs to be considered in terms of both key mandates i.e. maintaining price stability as well as financial system stability. 

There are arguments that the goals a central bank needs to achieve should be determined by the political process. However, then the central bank should be able to pursue the goals as it sees fit with appropriate accountability. Ben Bernanke, former Chairman of the Board of Governors of the Federal Reserve System, has stated that central bankers, subject to short-term political influence, may face pressures to over-stimulate the economy to achieve short-term output and employment gains that exceed the economy’s underlying potential. He said that political interference in monetary policy can generate undesirable boom-bust cycles that ultimately lead to both a less stable economy and higher inflation. 

The following remarks made by economist David Ricardo nearly two centuries ago regarding this issue are very valid even in this day and age: “It is said that Government could not be safely entrusted with the power of issuing paper money; that it would most certainly abuse it....There would, I confess, be great danger of this, if Government--that is to say, the ministers--were themselves to be entrusted with the power of issuing paper money.”

It can be argued that fiscal consolidation is a vital prerequisite to make central banks independent. A revenue-based fiscal consolidation path is a priority which needs heightened attention in the Sri Lankan context. It must also be recognised that there is a role to be played by each stakeholder to achieve sustainable economic development. In essence, aligning all major policies to the growth trajectory and executing them efficiently has to be a collective task. 

Claudio Borio (2019) states that people have come to believe the economy is a simple machine and the interest rate lever is sufficient to do the job. Therefore, when growth falters and central banks are unable to restore it, they are accused of not doing enough and for misusing their independence. The inability of central banks to convince the authorities of the importance of having a balanced mix of fiscal, monetary and structural policies may lead to reputational risks. 

Central banks should be sufficiently independent to draw clear demarcations for their mandates when more and more delivery outside their scope is expected. Unduly widening the scope of expectations from central banks can become a grave challenge. Central banks need independence to demand clearly defined mandates. Based on country-specific circumstances, functions of central banks need to be ring-fenced, avoiding blurred boundaries between them and the other Government entities. In the final analysis, central banks will be held accountable for failure to meet core objectives, and no other entity will come forward to share the blame.

Accountability: the other end of the spectrum

Independence and accountability are two ends of a spectrum. In simple terms, accountability requires central banks to be answerable for their decisions. When accountability is in place, justification of decisions of central banks would not be an arduous task. Decision-makers at all levels of central banks need to act with probity. Appointment of the members of the governing authorities of central banks needs to focus on key requirements such as expertise, experience, reputation, conflict of interest and independence of mind, time commitment and collective suitability. 

Yves Mersch, Member of the Executive Board of the ECB (2019), states that inappropriate behaviour by policymakers can damage the reputation of central banks and be used by politicians to build a narrative against independence. Institutionalising the independence framework enables central banks to be free from day-to-day politics while being held politically accountable for their decisions. Central banks need to be insulated from short-term expedience so that they can focus on stable growth of the economy in the medium/long-term. 

A common observation in several advanced and developing economies is the pressure mounting on central banks to boost short-term growth during the latter stages of election cycles. Functional independence and smooth fiscal and monetary policy coordination are important elements to take appropriate monetary policy decisions in such contexts. Careful selection of monetary policy tools will stand as an ever-present challenge for central bank accountability. Gauging the appropriateness of policy decisions is crucial in this exercise. Strict monitoring of “appropriateness” of decisions enables central banks to take the “punch bowl” away from the party at the correct time.

Should central banks be liable for financial crises? The unnoticed silent duty 

Central banks are facing many challenges in taking regulatory decisions under the remit of the financial system stability mandate. In the case of Sri Lanka, it is observed that the CBSL faces more criticism against the decisions related to regulation and supervision of financial entities than its monetary policy-related functions. However, such claims need to be considered in the context of the level of the financial literacy of citizens, depth of the financial system, and efficiency of the legal system of the country. 

Expecting CBSL alone to bring resilience to the financial system is not justifiable given the deficiencies in aforesaid areas. Institutions in the financial system, as well as the depositors and investors, have roles to play towards this objective. Creating a conducive environment for a deep and stable financial market needs the support of the Government as well. The CBSL delivers a silent duty in ensuring the financial system resilience of the country. Simply because of the noises stemming from several fragile finance companies, one should not forget the role played by CBSL to ensure that licensed banks and finance companies are subject to regulations issued in accordance with international best practice. 

It is CBSL’s success in this respect that has created the buffers that are enabling financial institutions to bear the burden of supporting a fiscally constrained government to save livelihoods and businesses during the current unprecedented crisis. Central banks are all about stability. However, designing regulatory frameworks underpinned by the concept of “proportionality” is another challenge faced by central banks during the journey towards balancing financial stability with supporting growth impulses in the economy.

Avoiding misunderstandings through improved transparency 

Former Governor of the Bank of England Mervin King described central banking during the earlier period when it was less transparent as “a dark art, practiced by magicians, and wrapped in security”. Misinterpretation or misunderstanding of the communications made by central banks poses a serious challenge in executing decisions. It is also an inhibiting factor for efficient and effective engagement with general public. One should not forget that transparency has its limitations and unintended consequences as well. According to Christian Hawkesby, Assistant Governor of the Reserve Bank of New Zealand, publishing projections can portray a false sense of precision and that greater transparency does not necessarily equate to increased clarity for market participants and the public. An effective Right to Information regime, consulting market participants prior to introducing key regulatory requirements and open dialogues with civil society regarding policy matters can be catalysts in addressing transparency issues. 

Following up words with deeds 

A report of Ernst & Young’s central banking team states that today in many countries, governors are as well-known as the government leaders they serve, and their words and deeds are the subject of heated debate in newspapers, bars and taxis. When central banks fail to succeed in meeting the objectives, people tend to distrust their policies. Central banks are therefore, required to take measures to preserve their credibility by implementing what they promise in their policy decisions. 

In the absence of the public trust in central banks, it becomes difficult to introduce innovative and decisive responses to challenging economic situations. Models and forecasts used in relation to inflation targeting require constant accuracy verifications. Revising such forecasts owing to the change of circumstances need to be shared with the public and carefully explained. Bridging the competence gap of central bank staff is also of paramount importance to enable them to be reliable central bankers who can adapt to a rapidly changing global order.

Maximising synergies between the objectives instead of trade-offs.

Although all central banks are not entrusted with the responsibility of maintaining financial system stability, the latter becomes significant in terms of an effective monetary policy transmission mechanism. Concerns that arise in the financial system stability sphere create spillover-effects for monetary policy decisions as well. 

Global financial turmoil provides a clear example of the severe adverse impact a financial system crisis can have on the real sector. The growing importance of financial system resilience in making monetary policy effective has compelled central banks to take prompt corrective actions in respect of fragilities in banks and other entities. It has been evident in Sri Lanka that investment decisions of people get influenced by failures of financial institutions irrespective of the size of such entities. 

Both the prudential and conduct of business regulations need to be given equal importance in preserving financial system stability as a pre-condition for effective monetary policy. With the growing integration of financial markets, cross-border financial stability has also become important. Enhancing financial literacy and inclusion are other key challenges to overcome in gaining maximum benefit of synergies between the two mandates of price and financial system stability. 

Central banks will be compelled to have persistent reviews of the regulatory architecture in striking a subtle balance between the said stability goals. The macro-prudential surveillance function can play a pivotal role in assisting central banks to address the cross-sectional dimension of systemic risk. However, central banks cannot downgrade the significance of micro-prudential policies to preserve the safety and soundness of individual financial intermediaries. The ability of banks to release capital buffers which had been built under the influence of macro-prudential policies to ease the pressure on monetary policy frameworks in facing Covid-19 induced challenges demonstrated the benefits of leveraging synergy between the two key mandates. 

Ensuring check and balance systems in digital transformation and technological innovations

The emergence of Fintech companies has challenged traditional banks and financial firms by lowering the cost of finance and enhancing access to finance. However, central banks need to ensure that systemic stability risks emanating from the Fintech industry is mitigated and traditional financial firms redesign their strategies to meet the challenges posed by such rapid transformations. 

Fully digital banks and Peer-to-Peer lending platforms have created disruptive effects which require appropriate regulatory responses from central banks. In overcoming these challenges, central banks can promote collaborative engagement of traditional banks and the Fintech industry instead of a competitive approach in the financial eco system. In going forward, central banks need to clearly recognise the importance of being agile to welcome advantages of digitalisation while addressing stability risks entailed by technological change.

Should central banks rush for digital currencies?

Traditionally central banks have been functioning as currency issuing authorities. However, along with the development of “Bitcoin”, “distributed ledger technology” and “blockchain” there is a growing consensus for central banks to consider moving to the territory of digital currency. Several central banks have already launched their experimentations in this regard. Given the practical questions relating to implementation of monetary policy decisions in a digital currency regime; the impact on the financial intermediary function of banks; and the optimal design of such currency, switching to digital currencies requires a comprehensive study of the implications of such a policy. This will be a challenge which needs cautious consideration of central banks in terms of the road ahead. 

Post COVID-19 challenges

Central banks worldwide were pressurised to direct banks to provide credit support to COVID-19 affected businesses. Now the challenge faced by central banks as financial regulators is to ensure banks build up capital and liquidity buffers to face future fragilities. Rising NPLs and bankruptcies of businesses and households have exacerbated the post Covid-19 challenges for central banks. 

As emphasised by the World Bank, banks will be required to redesign their business models and the financial systems need deep restructuring to withstand such future vulnerabilities. Obvious requirements for central banks in this backdrop would be changing regulatory policies and close monitoring of short- and medium-term growth trajectories. Central banks need to drive a balance between credit supply to the real sector and stability of banking system. They will have to move along with the awareness that low interest rate regime will not guarantee the long-term health of economies.

Conclusion

Independence for central banks does not mean the requirement for them to act in complete isolation. When working with democratically elected sovereign governments, central banks are required to be flexible to ensure effective and efficient coordination between fiscal and monetary authorities. At the same time, effective engagement with the public is a requirement that needs to be given foremost priority. 

Media and civil society can also play a vital role in raising voices to support the independence of central bank decision making processes, as ultimately the whole of society can be victims, if a central bank loses its capacity to support government policies by pursuing its mandates professionally while balancing short-term compulsions with the need for stable growth and prosperity in the medium-term.

In the context of the global growth slowdown due to the Covid-19 induced crisis, as well as trade and technology tensions between major economies, central banks will be pressurised in an unprecedented way to accelerate economic recovery. However, while central banks are implementing unconventional monetary policies, there should be burden-sharing with the fiscal authorities; and the private sector will also need to come forward to ensure that the right policy mix is available for this exercise. 

Policies to reduce central bank financing of governments coupled with improved fiscal discipline should also attract the serious attention of the authorities. Expecting to deliver quasi-political tasks by central banks is a challenge to be overcome through clearly determined boundaries for central banks. When the space for manoeuvre is constrained for monetary policy, fiscal policy needs to be redesigned to have a growth-friendly focus. Otherwise the collateral damages of accommodative monetary policies can outweigh its advantages. When both monetary and fiscal policies are constrained, urgent priority should be attached to accelerating structural reforms to boost growth and employment to avoid eventual over-heating of the economy. 

Central banks worldwide cannot delay the process of keeping pace with the rapid development that is taking place in the technological, communication and social arena. Protecting consumers and investors should also be a key imperative. In pursuing global solutions for universal crises, central banks need to foster a culture of regional and global cooperation. Risk of another crisis cannot be completely ruled out. Therefore, central banks better gather all their strength to prepare for such growing uncertainties.

The CBSL has overcome many challenges during its journey over seven decades amidst a devastating civil war, natural disasters and political instability. However, the Bank has celebrated many fulfilling outcomes as well during this period and it is continuing the effort to become a strong, stable and unique organisation well prepared to withstand unfolding uncertain times. At the 70th anniversary of CBSL, we wish the Bank may always receive the strength to navigate turbulent times ahead in steering the nation towards prosperity while being a strategic partner of an inclusive socio-economic development agenda that is stable over time.

“Central banks will require strong nerves if they decide to take away the punch bowl just as the party is getting going.” - Charles Goodhart

The writer is the Deputy Director, CBSL, Attorney-at-Law. The views and opinions expressed in this article are those of the writer and do not necessarily reflect the official policy or position of any institution. She can be reached via email at [email protected].