Central Bank’s Monetary Policy Review: Is there a hidden macroeconomic anomaly?

Monday, 29 September 2014 00:00 -     - {{hitsCtrl.values.hits}}

The monthly monetary policy review The Central Bank issued its monthly Monetary Policy Review on 23 September 2014 (available at http://www.cbsl.gov.lk/pics_n_docs/02_prs/_docs/press/press_20140923e.pdf) Monetary Policy Review, September 2014). The statement has presented an analysis of developments which the Bank has identified as beneficial to Sri Lanka before announcing the policy change which it has introduced in the month. The coverage of the period relating to these developments has differed from one field to another perhaps due to the problem of non-availability of updated data. Accordingly, growth has been analysed pertaining to the first half of 2014. The developments relating to external trade and balance of payments and those relating to money supply have been analysed with respect to the first seven months of the year. The change in the inflation rate has been presented up to the end of August, the latest month for which the relevant data had been available.   Punishing banks for parking their excess money continuously Based on these analyses, the Bank has introduced its monetary policy change pertaining to the acceptance of excess money available with commercial banks as a temporary deposit with the Central Bank under its new Standard Deposit Facility, also known as SDF. In this facility, commercial banks can keep their excess money in deposit with the Central Bank at an annual interest rate of 6.5%. However, they do not get a security for such deposits from the Central Bank as in the case of a REPO transaction where the Central Bank gives away the Treasury bills from its holdings. The Central Bank has accused commercial banks of using SDF continuously to park their excess money – money available after lending to customers and to other banks – with the Central Bank instead of lending to customers. To discourage them from doing so, the Central Bank has changed the rules of the game. Under the new rules, any commercial bank which will use this facility for more than 3 times a calendar month will be paid a lower interest rate at 5% per annum, a kind of a penalty imposed on banks for their wrong behaviour. Thus, commercial banks which have been accused of being lazy in lending have been forced to go out to the market and start lending their excess money to the public instead of making easy money with the Central Bank.   Thumping profits do not testify to the presumed laziness of banks The Central Bank has observed that the credit to private sector by commercial banks has remained ‘modest’ in the last 12 months. What the Bank has termed modest is the stagnant position of private sector credit at about Rs 2.5 trillion between July 2013 and July 2014. This has happened despite the Bank’s reducing interest rates to promote credit as a part of its loose monetary policy in the last two years or so. To promote credit in the economy, the Bank had continuously reduced its policy interest rates which in turn had caused commercial banks to reduce their lending and deposit rates. However, the reduction in lending rates is expected to promote credit by increasing the demand for credit by borrowers. But the credit to private sector has remained obstinately stagnant when all other economic indicators had shown a robust growth as claimed by the Central Bank. There could only be one reason for this freak outcome. That is, borrowers would have flocked in front of banks to borrow money but banks would have sent them away. That was because banks were more interested in earning easy money by depositing their excess money with the Central Bank. The interest rate which banks could earn by resorting to that practice is 6.5%. This rate is ‘extremely modest’ compared to the high income they would have earned by lending in the market as demonstrated  by the weighted average lending rates of commercial banks standing between 14 to 16% in the last 12 months according to the Central Bank’s latest weekly economic indicators (available athttp://www.cbsl.gov.lk/pics_n_docs/_cei/_docs/ei/wei_20140926.pdf). If a profit seeking bank chooses 6.5% over available opportunities at more than two times that rate, such commercial bank is surely a lazy bank and need be woken up. However, the thumping profits measured in billions of rupees earned by the entire banking system in the last few years do not testify to their being lazy in lending or doing business.   Waging an interest rate war with banks It now appears that the Central Bank has entered into an ‘interest rate war’ with the entire financial market of the country. When banks did not lend money to the private sector as expected by the Central Bank, it started to reduce its policy rates in several rounds. Accordingly, its REPO rate – the rate at which it accepted the excess money of commercial banks by giving away the Treasury bills it had as collateral – was reduced from 7.75% in mid 2012 to 6.5% by end 2013. This was the rate which was continued under the Central Bank’s new SDF introduced in early 2014. Along with the reduction in policy rate in each round, all interest rates in the financial markets, including the lending rates of commercial banks, were brought down appropriately. For instance, the interbank call money rate, on average, came down from 10.47% in mid 2012 to 7.66% by end 2013. Similarly, the weighted average lending rate of commercial banks came down from 15.93% in mid 2013 to 13.53% in mid 2014. Yet, credit to private sector did not grow as expected resulting in an accumulation of a substantial amount of excess money with commercial banks. In the last 12 months, this excess money had amounted, on average, to Rs 340 billion. Central Bank’s Deputy Governor, Nandalal Weerasinghe, a reputed economist himself, in an interview with a private TV channel immediately after the change in the monetary policy in September signalled that if banks will not extend credit as expected, the Central Bank would further cut interest rates. Clearly, with such an interest rate cut, the future will be a borrowers’ market and not a lenders’ market.   Discouraged depositors will help eliminate excess money Commercial banks on their part have been mindful of this reality. They are competing with each other to get the borrowers to their portfolio by employing different marketing tactics. Normally, the situation in any market would be for banks to use such marketing tactics to attract deposits. But now, deposit mobilisation at great costs has become costly since it does not pay enough return to banks. Hence, banks are now discouraging deposits by offering the depositors unattractive very low interest rates when the maturing deposits are renewed. But on the lending side, banks have been sending their field canvassers on motorbikes to push loans on prospective borrowers. Last week, one such field canvasser had offered a large loan to a housing developer at 10.5% per annum. The housing developer has not committed himself to the loan because he is awaiting a further interest rate reduction by the Central Bank. His stand is perfectly rational since the Bank has signalled a further fall in interest rates along with the expected decline in inflation rate. As such, the market expectation is that Sri Lanka will move toward a zero interest rate regime like the regime found in Japan, EU, the UK and USA. The signs for such a movement were evident when the Central Bank imposed the penalty interest rate on SDF if banks used that facility for more than three times a month. Showing that all banks had been in this game, the entire short term interest rate structure came down by a significant margin immediately: Call money rates from 6.69% to 6.22%, REPO market outside the Central Bank from 6.52% to 6.03%, 1 year Treasury bill rate from 6.29% to 5.89%, Weighted average yield on Treasury bonds from 10.58% to 9.23%, and NSB 1 year fixed deposit rate from 7.5% to 6.5%. To match these savings rates, the lending rates of commercial banks too have fallen by a significant margin: Weighted average prime lending rate that is applicable to best customers of banks from 7.15% to 6.75% and weighted average lending rate from 13.83% to 13.53%. Accordingly, the Central Bank’s policy change has subsidised borrowers while taxing the savers. However, it appears that this subsidy is not attractive enough for borrowers to show up in banks because they are waiting for further interest rate cuts. In this scenario, the excess money will eventually disappear when discouraged savers would take their money out of banks.   Increased consumption will increase the import bill What will the savers do with their money in hand? They will simply use it for boosting consumption as has been done in other countries where interest rates had been brought to zero level. Sri Lankans have always been high consumers, using about 82% of their income for consumption. This new measure will further boost that consumption habit of fellow citizens. And what will they consume? They have a high tendency for consuming imported products and therefore it will boost the import bill as well. The likely candidates are smart phones, large flat TV screens, Hybrid cars and foreign travel for pleasure which are vogue in demand in the present days. The outcome is the reversal of the current contraction of the combined trade and services deficit putting pressure for Sri Lanka to borrow more to generate its much praised surplus in the balance of payments. Hence, in an open economy where the domestic market is small, boosting consumption by discouraging savings will not be an advisable policy stance. It will create a serious anomaly in the country’s macro economy.   ‘Creditless growth’, the marvel of Sri Lanka But, from another side, should the borrowers be subsidised by the Central Bank? It appears that they should not be. This is because, despite the stagnant private sector credit levels, Sri Lanka’s economy has recorded an impressive growth in the past 4 quarters. Ironically, it can therefore be labelled a ‘creditless growth’ which the economy has attained without the support from the credit side. According to the estimates of the Department of Census and Statistics or DCS, Sri Lanka’s economy has grown by 7.6% in the first quarter of 2014. This was accelerated to 7.8% in the second quarter http://www.statistics.gov.lk/national_accounts/Press%20Release/DCS-GDP-2014-Q2.pdf. This growth has basically come from industry which has grown by 12%, construction by 20%, domestic trade by 10%, post and telecommunication by 10%, banking by 6% and government services by another 6%. Except the government and banking sectors, all other sectors are highly credit dependent sectors. If they can record these impressive growth rates as claimed by DCS with stagnant credit levels, bank credit is unnecessary for boosting the economy. In this sense, Sri Lanka’s creditless growth is an icon for the rest of the world since no country has recorded such a marvel in the past. Countries had had creditless recoveries but not creditless growth. As such, the current obsessive pursuit of promoting credit by reducing interest rates appears to be unnecessary.   Anomalous growth numbers by DCS Though DCS has come up with an impressive growth record, the examination of some of the high growth fields shows that the rates reported do not tally with other available economic indicators. One example is the growth in the factory industries. According to DCS, the factory industry sector has recorded a growth of 11% in the second quarter of 2014. But according to the Central Bank’s factory industry production index as reported in its weekly economic indicators referred to above, the production level has remained stagnant at 108 between May 2013 and May 2014. In the case of wearing apparels of which DCS has recorded an impressive growth of 16%, the Central Bank’s index shows a decline of 5% in production. A similar anomaly is found in the construction sector too. According to DCS, this sector has grown by 20% in the second quarter of 2014. But the import of building materials, vehicles, machinery and equipment has declined in that quarter compared to the relevant quarter in the previous year by 14%. Hence, the presumption is that the entirety of the construction that has happened in the quarter under reference has come from domestic sources which fact is highly unlikely. In the transport sector of which the Railways have been running at a huge deficit, a growth of 5% has been recorded implying that it has made a positive value addition. It is therefore evident that appropriate cross-checking and verifications have not been done by DCS before releasing its growth numbers. Apparently, the Central Bank too has accepted these numbers without making an independent compatibility analysis.   Banks and depositors are being punished for the policy-created anomaly in the macro economy The money supply and reserve money numbers also show a macroeconomic anomaly. The monetary policy statement of the Central Bank under reference has reported that the financial account of the balance of payments has recorded a surplus of over US$ 2 billion during the first 7 months of 2014. This surplus is identically equal to the increase in the net foreign assets of the Central Bank during this period. According to numbers reported in the weekly economic indicators and the Central Bank Annual Report 2013, the net foreign assets of the Central Bank has increased by Rs 214 billion or US $ 1.6 billion during this period showing a discrepancy of US$ 400 million. At the same time, Reserve Money – money produced by the Central Bank by acquiring foreign exchange and lending to the government on a net basis and used by commercial banks to create multiple deposits and credit - has increased from Rs 489 billion at end-2013 to Rs 524 billion at end-July2014. Since the Central Bank’s net credit to government has increased only from Rs 114 billion to Rs 141 billion during this period, the entirety of the increase in reserve money has taken place due to an increase in its net foreign assets. This is however on the presumption that all other miscellaneous operations of the Central Bank have remained unchanged. But when the reserve money has increased by 7%, the broad money supply has increased by 12%, indicating that commercial banks have started creating multiple deposit and credit in the system which will be completed over the next 12 to 18 month period. But who has used that credit? According to the Central Bank’s monetary policy statement, it is the government which has used that credit given that public corporations have repaid some of their borrowings and the private sector credit has remained stagnant. According to the data released by the Central Bank, lending of banks to the government has increased by Rs 153 billion between end-July 2013 and end-July 2014. Thus, the Central Bank has acquired net foreign assets through the borrowings of the government and other government agencies to build reserve money in the economy. Such reserve money has basically been used by banks for lending back to the government at the expense of the private sector. Now banks and savers are being punished due to this policy-initiated anomaly created in the country’s macro economy.   An elephant in the room? If banks are forced to lend to the private sector through policy initiatives, they will lower their credit standards creating a credit snowball similar to the credit bubble that hit the US economy prior to the financial crisis of 2007-08. Since the economy is unable to sustain this credit snowball, it would start to meltdown in no time. It is an invitation for an unwanted financial sector crisis in the country. Thus, the obsessive pursuit of promoting private sector credit by distorting interest rate structure has created an elephantine macroeconomic anomaly. But the elephant is not out in the wild. It is right inside the room and its threat should not be ignored. (W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected]

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