New central banking bill: Positive but gaps need to be filled – Part I

The Central Bank should be made independent not because IMF or US Senate Committee insists it. It should be made independent because it is for the good of Sri Lanka citizens

History of central banking bills

The Ministry of Finance has released the new central banking bill, drafted by the Central Bank and to be presented to Parliament as a Gazette notification for the information of the public (available at: http://www.documents.gov.lk/files/bill/2023/2/299-2023_E.pdf). This is the third time that a new central banking bill has been released by the Ministry of Finance during the last two decades. Ironically, on all these occasions it was Ranil Wickremesinghe who was the head of the state, on the first two occasions as the Prime Minister and, on this third occasion, as the President. 

The first occasion was in 2004 when the Central Bank with technical support from the IMF and the World Bank planned to introduce a new central banking act under its modernisation program. I had the privilege of running this project under the direction of Governor A.S. Jayawardena. Ranil had agreed to enact it, but unfortunately for him and the Central Bank, the government was changed in mid-2004 and the new government headed by Mahinda Rajapaksa chose to shelve it. 

The second occasion was in 2019 when the project was steered by the present Governor Nandalal Weerasinghe under the stewardship of the then Governor Indrajit Coomaraswamy. Ranil had been persuaded by his finance minister Mangala Samaraweera and state ministers Eran Wickramaratna and Harsha de Silva to enact it in Parliament. The bill was gazetted, but it could not be presented in Parliament due to the change of the government in November that year. The new government headed by Gotabaya Rajapaksa chose to ignore it. 

Central Bank should be independent for the benefit of people

After these two failed attempts, the question of introducing a new central banking act has come into prominence with Sri Lanka seeking a bailout package from IMF. It has been stipulated by IMF as a precondition for the bailout package. Going by IMF, the US Senate Committee on Foreign Relations too has indicated that making the Central Bank independent is a prior action for approving the package. Hence, Sri Lanka has no choice but to introduce a new legislation to make the bank more independent. The Central Bank should be made independent not because IMF or US Senate Committee insists it. It should be made independent because it is for the good of Sri Lanka citizens. 

CB has policy and budget independence even under the present law

When the Monetary Law Act under which the Central Bank has been set up was enacted in 1949, its architect – John Exter – had introduced several provisions to give the Central Bank a certain degree of autonomy. It was given independence to formulate monetary policy, known as policy independence, and to decide on its own finances, known as budget independence. Unlike the other government corporations, the minister in charge cannot issue general or special directives to the Central Bank. Hence, the Bank is fairly insulated from undue political interference. 

Provisions that compromise CB independence

However, there are a few other provisions that have compromised the autonomy of the Bank. One is the permanent vote carrying seat given to the Secretary to the Ministry of Finance on the governing body of the bank, known as the Monetary Board. John Exter expected the Secretary to function as a conduit between the Monetary Board and the Minister. But in practice, this officer has become an influencer of the Monetary Board’s decisions. 

Another provision was the permission given to the Central Bank to buy Treasury bills from the primary auctions. Exter expected Treasury bills to be a short-term financing repayable within a year. Hence, if the Central Bank had provided funds to the Government by investing in Treasury bills, since it was repaid within the year, there could not be an adverse impact on the Bank’s monetary policy targets. Once again in practice, Treasury bills became a permanent source of funding forcing the central bank to open a permanent funding line to the government. When this became inflationary, the bank had to increase interest rates and cut down credit levels which were a punishment of the private sector.

Another contentious provision was the temporary liquidity facility being provided by the Central Bank to the Government under its provisional advances. This was in line with the Central Bank’s role as the banker to the Government, namely, maintaining government accounts, helping it to have payments cleared, and providing liquidity finance via overdrafts. Since provisional advances, set at 10% of the estimated revenue of the government for the next year, operated like an overdraft, it was expected to be self-repaid. But in practice, it became a permanent overdraft where the limit was increased every year with increases in the estimated government revenue. This facility also adversely affected the bank’s monetary policy programs. 

Prudent and responsible money printing

The Central Bank is the only institution empowered by law to issue money in Sri Lanka. The bank is expected to accomplish this task prudently and with responsibility. That is because money primarily being a medium of exchange is needed to permit smooth transaction of goods and services produced in a country. 

If money is not adequately supplied which ordinary people refer to as money printing today, the shortage force transactors to use the same money stock again and again. This is called the velocity of circulation of money, the number of times a given unit of money will change from hand to hand. If this increases unduly, the result is like the increase in the money stock leading to a fall in the value of money or inflation. Hence, the prudent and responsible money printing requires the Central Bank to set its money issue target equal to the growth in the real economy. 

If it is done excessively, the result is the generation of inflation in the economy, a gradual increase in the general price level reducing the real value of all financial assets, including money, held by people. This should be avoided but the past performance of the central bank shows that, due to undue influence of the politicians, exercised through the finance secretary who dominates the decision making of the Monetary Board, money has been excessively issued. The result has been the gradual fall in the value of money as shown even by the underestimated Colombo Consumers’ Price Index or CCPI. 

The base year of this index has been changed several times since it was introduced after independence in 1952, the latest being in 2021 based on the Household Income and Expenditure Survey conducted by the Department of Census and Statistics in 2019. When it is converted to a single series beginning from 1952, the value of the index that amounted to 100 in that year has shot up to 21,512 by end-February 2023. What this means is that a rupee in 1952 is now worth half a cent. This is the malaise created by the central bank that has yielded to the demands of politicians in the past. The objective of the new bill is to remove the source of this malaise. 

New central banking act

There are many positive aspects of the new bill. Compared to the existing Monetary Law Act or MLA, it is certainly an improvement. But compared to the bill that was drafted in 2004 and the emerging best global practices, there are gaps that need be filled. 

First, the positive sides. 

Central Bank as the legal person

In the new bill, it is the Central Bank which has been incorporated. Hence, the Central Bank has a legal existence, and people can take the bank to courts. In the MLA, a weird situation has been created by incorporating not the Central Bank, but a body of people – at the beginning it was a board of three, but now five – called the Monetary Board leading to confusion as well as problems about accountability. This inaccuracy is proposed to be corrected in the new bill. The bill specifically stipulates that the Central Bank is autonomous and accountable which has not been clearly spelt out in the MLA. 

New governance structure

The Central Bank has a two-tier governance structure in the proposed bill replacing the Monetary Board. At the top, there is a Governing Board of seven members which has the overall responsibility for the Central Bank. On par with the Governing Board, there is another board called the Monetary Policy Board made up of 11 members with responsibility to carry out monetary policy measures. An anomaly made there is that all members of the Governing Board are also members of the Monetary Policy Board. As a result, the monetary policy is not conducted by the Central Bank independent of the functioning of the Governing Board. 

Governor functioning as the chairman of both boards provides further confusing link about the ultimate accountability of the bank. If monetary policy is abused or twisted, the Governing Board members are also accountable for the same, though it is determined by a separate body. Since the Monetary Policy Board has two other experts and two Deputy Governors as members, they are not accountable for the missteps taken by the Governing Board. This is not a suitable governance arrangement. All these people are recommended by the Minister of Finance. Hence, the likelihood of those loyal to him being recommended has not been eliminated. 

Removal of Finance Secretary from boards

An important change introduced in the new bill is the removal of the Finance Secretary from the decision-making process of the Central Bank. He is not a member of either board. However, he has been given a role in the Central Bank as a member of a new council called the Coordination of Fiscal, Monetary, and Financial Stability Policies Council which is simply a body to share information and exchange views on macroeconomic development, outlook, and risks. The Governor is the chairman of this council, and it is represented by the government by Finance Secretary and Secretary to the Ministry of Economic Policy, if such a ministry exists. Otherwise, it is a two-person exchange of views which cannot have a chairman.

It seems that this council is a forum for the Government to inform the Central Bank of its position, on one side, and be informed of the action and policy of the Government, on the other. There is no provision that the Governor should officially place the transactions that take place in the council before the Governing Board or the Monetary Policy Board. This communication line has not been spelt out. Further, the bill specifically says that to avoid doubts, the council has no authority to make decisions over the fiscal, monetary, and financial stability policies. This is a blurred area of governance arrangement between the government and the Central Bank. It is doubtful whether it will deliver any useful results. 

Objectives of the bank

In the existing MLA, both the economic and price stability and the financial system stability have been made core objectives of the bank ranking on par with each other. Therefore, they are also referred to as co-objectives. This is a confusing state because it renders the bank inactive especially if financial institutions fail in an inflationary situation. To resolve inflation problem, the bank is required to tighten money flows from the bank, but to rescue the financial institutions it should do the opposite. It is a strange situation where the bank is unable to meet either objective. 

To eliminate this dilemma, in the new bill, it is specifically ruled that the primary objective of the Central Bank is to achieve and maintain domestic price stability reckoning, among others, the need for filling the gap between, if any, the potential output and the actual output. This situation arises only when the actual output is below the potential output resulting in the economy to underperform. In that scenario, the Central Bank must loosen monetary policy temporarily abandoning the strict inflation targets it is committed to follow. 

Since the Central Bank should sign a monetary policy framework at the beginning of the year with the minister of finance setting out its inflation target, any deviation from it will be construed as a failure of the bank. Hence, these additional provisos to the primary objective of the bank set out in the new bill will make the monetary policy operations non-workable. 

System stability 

The secondary objective of the Central Bank as set out in the new bill is to secure the financial system stability. What this means is that if there is a conflict between the price stability objective and the financial system stability objective, the bank should give priority to the former ignoring the latter. Accordingly, the bank’s task will be to see that the system is stable through its regulation and supervision of financial institutions on an individual basis, on one side, and ensuring macroprudential regulation of the financial system from the system’s point, on the other. In the case of failed or problem institutions, the bank should resolve them either by closing them or by infusing capital into them. Since closure of an institution is a near impossibility in Sri Lanka in the present political environment, finally, it boils down to rescuing them through new fund infusion by way of capital and/or loans. 

The Central Bank cannot fund them if it is fighting inflation in the system. In these circumstances, it will be the Government which will have to rescue these institutions. The new bill specifies that the bank should get government funds for this purpose after consulting the minister of finance who in turn is required to get the approval of the Cabinet to spend public funds for this purpose. However, it presumes that the problem-ridden financial institutions are bailed out through external funding. 

While the details of the resolution procedure have not been spelt out in the bill, it would have been helpful if the emerging global trend in financial firm resolution, namely, getting those inside financial institutions like shareholders, depositors, creditors, and even employees to take leadership in bearing the resolution burden known as bail-ins, had been accommodated within the provisions of the bill. As it is, if a bail-in is to be implemented by the Central Bank, a separate law empowering it to do so need be enacted in Parliament. 

Banker to government

In the MLA, the Central Bank is the banker to the Government and so is in the new bill too. John Exter has been criticised here for permitting the Central Bank to invest in the primary issue of Treasury bills as well as for opening a liquidity financing facility called the Provisional Advances set at 10% of the estimated revenue of the government for the next year. However, the new bill has debarred the Central Bank from granting direct or indirect credit to the government or any other public entity excepting government owned financial institutions which the Central Bank should lend funds under the bank’s system stability objective. 

Accordingly, the bank has been debarred from purchasing any security, mainly Treasury bills, from the primary market thereby putting a stop to the Central Bank-funding of the budget provided for in the MLA at present. Any purchase can be made in the secondary market to facilitate the Central Bank to conduct its open market operations as a monetary policy instrument. However, such purchases should not amount to a lending to the government directly or indirectly. Similarly, in the new bill, the granting of provisional advances has been severely curtailed as described in the following para. 

New provisional advances 

Special provision has been made in the transitionary provisions about how the curtailed provisional advances should be made to the Government. A new provisional advance can be made by the bank in the first month of the year at the prevailing market interest rates not exceeding 10% of the actual revenue of the Government in the first four months of the previous year. However, this should be repaid within six months making them truly provisional advances. This is to enable the Government to commence its budgetary operations in a new financial year without disruption because of the delay in raising revenue in terms of the tax proposals in the budget. 

To strengthen it, the Central Bank can buy government securities in the primary market within the first six months of the new bill coming to operation, but they should all mature within a year. The existing debt stock owned by the Central Bank can be converted to negotiable debt instruments maturing within 10 years enabling the bank to sell them in the market and liquidate the same. 

Accordingly, in the new bill, there are some strong provisions to prevent the Central Bank from accommodating Government’s funding requirements freely. This is one positive development there. 

In the next part, we will look at the gaps in the bill that need be filled. 

(To be continued)

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached [email protected].)