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No central bank, however powerful it is legally, can continue to fight with a market if the market moves in the opposite direction. At that stage, both the inflows to the Consolidated Fund and the Central Bank’s power to impose non-formal taxes on the economy collapse. Hence, interest groups may cheer when the Central Bank prints new money. But cheers today may end in tears tomorrow. This is a fine lesson which the current Monetary Board should apprise itself of before making any further move
A ferocious battle for the control of an empty fund
While the nation is wrestling with the deadly COVID-19, a ferocious battle has erupted between the Government and the Opposition for the control of what is known as the Consolidated Fund. Two months ago, it was an alien subject to the ordinary public. But today, it is a household name due mainly to the heated arguments over the media between the Government and Opposition members. 
Those who support President Gotabaya Rajapaksa claim that the President has powers to use the monies in the Consolidated Fund to provide public services uninterruptedly when the country is on an election mode despite the absence of a formal budget approved by Parliament.
Countering this claim, the Opposition argues that the powers which the Government had got to use these monies under the previously approved Vote on Account had expired on 30 April 2020. Hence, unless a new Vote on Account is approved by Parliament, public servants who make use of the monies in the Fund are violating the provisions of the Constitution.
Since both warring parties are quoting different provisions in the Constitution, it is a matter for the Supreme Court, as the interpreter of the Constitution, to make a ruling if it is brought to its notice. However, both parties appear to be ignorant of the fact that the Consolidated Fund is overdrawn, it has no money and if anybody wishes to incur expenditure out of it, it has first to be filled with funds.
Why is the Consolidated Fund overdrawn?
In terms of the Constitution, all cash inflows to the Government – by way of taxes, other revenues, charges, fees and loan proceeds – should be credited to the Consolidated Fund. This provision has been made in the Constitution to ensure that all receipts of the Government are collected into a single pool and expenses are incurred from this pool by a centralised authority accountable to Parliament.
Accordingly, the Constitution empowers only the Minister of Finance to use those moneys by issuing a certificate – called a warrant – as per the approvals given to him by Parliament when it approves the annual budget or, in the absence of a budget, a vote on account. Hence, the Consolidated Fund is similar to the normal cashflow statement of a company: money comes in and money goes out. If there is a shortfall, the company has to decide how the shortfall is met and if there is a surplus, how the surplus is utilised.
Since the Sri Lanka Government has been running deficit budgets throughout, the monies it gets by way of normal operations of the Government are insufficient to meet its normal operational expenses. The gap has to be filled by making a net borrowing – that is, borrowing more than the Government’s debt repayment liabilities. Since these borrowings do not take place at the required levels, the Fund is always overdrawn. What this means is that the Government has incurred some of the expenses in its books but since it does not have sufficient amount of cash, it is indebted to the nation by the overdrawn amount.
Overdrawn amount increases with budget deficit
There is an important observation that can be made about the Government’s cash indebtedness to the nation. That is, the overdrawn amount has been increasing over the years along with the increase in the budget deficit. For instance, as at the end of 2016, the overdrawn amount was Rs. 187 billion. This has increased to Rs. 286 billion at end-2017 and further to Rs. 304 billion at end-2018.
The numbers pertaining to end-2019 are not available since the Ministry of Finance has so far not released its Annual Report for the year. However, judging by the high budget deficit of 6.8% of GDP in 2019, an increase from the deficit of 5.3% in 2018, it can be surmised that the overdrawn balance may have exceeded even the amount overdrawn in 2018.
As for the first four months of 2020, with many revenue losing tax incentives introduced at the beginning of the year, the overdrawn balance in the Fund should still be higher. What this means is that the Consolidated Fund is like a dried up well and the battling parties have to fill it up before trying to draw water from it. This is the most difficult task faced by the Government or the Opposition parties in the current adverse circumstances.
How did King Parakramabahu I fill an empty treasury?
A similar adverse circumstance had been encountered by King Parakramabahu, I, when he became the overlord of the Dakshina Desa, roughly the present day Western and North Western Provinces, in the 12th century CE, according to the author of Chulavansa, the second part of Lanka’s chronicle ‘Mahavansa’.
Desirous of becoming the king of the whole island, he had asked his father’s Treasurer, equivalent to the Minister of Finance today, whether he had enough resources in the Treasury to fight a long war with other overlords. The Treasurer had been frank and informed the king that the funds had not been sufficient to wage such a war.
According to Chulavansa, the king, instead of imposing taxes on people, set up a special export processing zone, among others, called the Antharaanga Dhuura and exported many local products to the rest of the world to earn the necessary resources. That was how King Parakramabahu, I, had filled the overdrawn Treasury first – in today’s parlance, the overdrawn Consolidated Fund – to incur expenditure needed for his military campaigns.
What are the current adverse circumstances faced by the Government? There are at least three major ones.
The costly tax cut
The first adverse circumstance has been created by the government itself. That is, as per the promise given to the people in the Presidential Election, the Government formed under President Gotabaya Rajapaksa had at the beginning of the year introduced a generous tax incentive package which has been unbearably costly in terms of the Government’s revenue targets.
I had warned the Government before they were introduced that it would backfire by cutting sharply into revenue unless the damage should be controlled forthwith (available at: http://www.ft.lk/columns/Tax-cuts-Control-the-damage-before-the-unconventional-stimulus-backfires/4-691207). The estimated loss in revenue had been at about Rs. 650 billion in 2020. As a result, the inflows to the Consolidated Fund has been curtailed significantly, creating a large hole in the Fund.
Counter measures have further reduced revenue
The second is the fallout from the COVID-19. As a counter measure to the spread of the disease, the Government had placed the whole country under continuous curfews. This measure, though desired from the perspective of COVID-19, had crippled the whole economy for many months. Since people could not pay taxes in time, the inflow into the Fund had been less than desired.
At the same time, on the expenditure side, the Government had introduced a deserving people support system by paying them a cash allowance of Rs. 5,000. This has increased the expenditure side from the Fund, leading to a bigger overdrawn balance.
Unfriendly global developments
The third is the unfriendly global atmosphere that had stood in the way of the Government to borrow money from abroad. The global COVID-19 pandemic has made the global financial markets virtually non-operating. On top of this, Sri Lanka was prevented from entering the market with confidence by two adverse developments. One was the downgrading of the country’s international borrowing ability by major credit rating agencies by one notch from B to B-, further qualified by a negative economic outlook.
The other was the fear among the existing international sovereign bond holders that the country would default its debt repayments. This was reflected in a sharp increase in the yield rates of Sri Lanka’s bonds in the secondary markets pushing down their market prices well below the respective par values.
For instance, the bonds maturing on 4 October 2020, according to the Central Bank data, had carried a yield rate of 44.42% as against a coupon rate of 6.25%. It in turn pushed down the price of a bond with a face value of $ 100 to $ 84.35. In comparison, this bond at end-2019 carried a yield rate of 4.1% and a premium price of $ 102.90. All Sri Lanka Government sovereign bonds are traded in the secondary markets today at a deep discount.
Hence, if Sri Lanka goes to the international markets to borrow money, it may have to offer a higher yield rate, higher than what it had been offering historically amounting to about 6-8%, to prospective investors. This has virtually closed the inflow of cash to the Consolidated Fund to fill its gap.
The failing domestic markets
In these circumstances, it is only from the domestic markets from which the Government could borrow money. That too has been crippled by two adverse developments. One is the effective borrowing limit for the Government as determined by Parliament. When the Vote on Account for the first four months of 2020 was approved last year, the borrowing limit had been fixed at Rs. 721 billion. Since there is no vote on account for the period from end-April 2020, there is no actual borrowing limit imposed by Parliament. Hence, the data show that the Government has exceeded this limit by about Rs. 120 billion in the expectation that the new Parliament after the General Election would give its covering approval to it.
The second is the Central Bank’s downward adjustment of its policy rates in a number of rounds of policy rate cuts to stimulate the economic activities suffered from COVID-19 counter measures. It appears that these rate cuts had been made against the market expectations as reflected in an upward trend in the secondary market rates, on the one hand, and the Central Bank’s inability to borrow through Treasury bills the entire amount it offers to the market, on the other. This unsubscribed part has to be purchased by the Central Bank and in the last two weeks alone such purchases had amounted to Rs. 18 billion.
Filling the Consolidated Fund with Central Bank’s printed money
Since the market is virtually closed for the Government, it has only one way to fill the gap in the Consolidated Fund. That is to borrow from the Central Bank which the laymen have erroneously termed ‘money printing by the Central Bank’.
But it is another way of imposing a tax on the economy without going through Parliamentary procedures, as argued by Paul Tucker, a former Deputy Governor of the Bank of England and current Chair of the US based Systemic Risk Council in his 2018 book ‘Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State’. It appears that the current government is using this unelected power of the Central Bank to its maximum.
Money printing is normal for a central bank
The Central Bank’s job is to create new liquidity in the financial system as demanded by the growth in the real economy. Hence, there is nothing wrong in a central bank printing new money if it is done safely and in accordance with accepted good practices. Since this is a process not well-understood by many, it is proposed to deal with it in detail here.
Reserve Money base: Barometer of printing money
The media and ordinary laymen seem to believe that when the Central Bank lends money to Government by buying its Treasury bills, an instance of money printing has occurred. This is only partly true since money printing can occur in the bank’s dealing with others too, namely, its own employees, the public, banks and financial institutions and foreign exchange suppliers. The sum total of these dealings is called the ‘Reserve Money Base’, or ‘Monetary Base’ or simply ‘Base’.
The net increase in the reserve money base is the net amount of new liquidity created by the Central Bank which the public call ‘money printing’. For instance, suppose the Central Bank has lent Rs. 200 to the Government. The reserve money base immediately increases by this amount. However, if the Central Bank has sold $ 1 from its foreign exchange holdings in the market, the original Rs. 200 newly created is withdrawn from the economy and kept hidden inside the bank. In that case, there is no new liquidity created and hence no new money being printed.
Therefore, the barometer for central bank’s money printing is not the amount it has lent to Government but the net increase in the reserve money base. For instance, from end-December 2019 to 6 May 2020, the Central Bank has increased its Treasury bill holdings by Rs. 224 billion. But the reserve money base has increased during this period only by Rs. 78 billion, the actual amount of new money printed.
How has the bank been able to perform this miracle? Partly by running down its foreign exchange holdings by $ 449 million and partly by siphoning off the newly-created liquidity through its open market operations. Hence, if the bank keeps its monetary policy in proper shape, it can maintain the new money printing under control.
The time bomb of reserve money increases
But this reserve money base is like a time bomb. It provides the needed seeds for commercial banks to create additional money and credit pushing up the total money supply in the country to a higher level. This process of new money supply creation by commercial banks takes about 12 to 18 months to run its course. But the multiple by which the new money supply can be created has increased to eight, meaning that every rupee created by the central bank by way of reserve money will end up in increasing the total money supply by about Rs. 8.
This is the danger of allowing reserve money to go up because if it is done excessively, the total money available in the economy will lead to price inflation, the tax which a central bank can impose on the economy without going through Parliamentary procedures.
Every game is a risky game but there are safe ways of playing the game without harming the players, referees and onlookers. How does this total money contribute to inflation and how can the central bank play this game safely?
No inflation if final money supply increase is equal to real economic growth
To illustrate this, take a very simple example and assume that we have only one good, coconuts, as a real product and money, the medium of exchange. If we have 10 coconuts and 100 units of money, the average price of a coconut is 10. If the units of money doubles to 200 when the total number of coconuts remains at 10, the price of a coconut also doubles to 20. However, if the number of coconuts too doubles to 20 when the amount of money doubles to 200, the price of coconut remains unchanged at 10.
If coconut is taken as the real output or real GDP and increase in coconuts as the real economic growth, the lesson that can be drawn from this simple example is follows: It is the money supply growth over and above the real economic growth that causes inflation. If the Central Bank wants to avoid inflation, it should keep the money supply growth exactly equal to the real economic growth. This is the money supply guide that is being used by all the central banks in the world. Those central banks which have violated this guide to please their governments have met with disastrous results. Our Central Bank is also a good example.
If growth is low, Central Bank’s freedom is also low
However, the central banks’ freedom to increase money supply without causing inflation is largely restricted if the economic growth is low. This was the experience of the Central Bank of Sri Lanka where the average economic growth in the last five years has been 3.7%.
For 2020, the bank has projected a positive growth of 1.5%. But all indications from all sectors show that it would be a negative 5%, taking away the bank’s freedom to print new money and help the Government in its present economic reconstruction programme. If it continues to support the Government without an exit plan, the country would be hit by inflation, while the economy is suffering from depression, a peculiar situation known as ‘inflationary depression’.
Inflationary depression: The worst nightmare of a central banker
This inflationary depression is the worst nightmare for a central banker since it reduces the bank to a mere cabbage, not able to move either forward or backward but just sitting on a table with no power of its own. In other words, the unelected power goes out of the window if the country is hit by inflationary depression.
Thus, when the country is in this state, the monetary policy transmission becomes totally ineffective making it necessary for the bank to threaten commercial banks to act as it commands. Already the signs are visible and the Central Bank, after reducing its policy rates recently, thought it necessary to take the whip and wave it threateningly at the recalcitrant commercial banks.
Today’s cheers may end in tears tomorrow
This is a sad state of affairs because no central bank, however powerful it is legally, can continue to fight with a market if the market moves in the opposite direction. At that stage, both the inflows to the Consolidated Fund and the Central Bank’s power to impose non-formal taxes on the economy collapse. Hence, as Paul Tucker has remarked in the book referred to above, interest groups may cheer when the Central Bank prints new money. But he warns that cheers today may end in tears tomorrow.
This is a fine lesson which the current Monetary Board should apprise itself of before making any further move.
(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])
