Paradox in Central Bank’s monetary policy: Not everyone approves of the policy direction

IMF’s Resident Representative for Sri Lanka and the Maldives, Dr. Eteri Kvintradze

Wrong monetary policy direction of the Central Bank

The IMF’s Resident Representative for Sri Lanka and the Maldives, Dr. Eteri Kvintradze, a former Deputy Minister of Finance of Georgia Republic, opined in a recent seminar at the Postgraduate Institute of Management or PIM that Sri Lanka’s monetary policy should be “forward-looking”. 

What she meant by “forward-looking” was that the monetary policy, instead of focussing on day-to-day inflation numbers, should be based on medium- to long-term price stability aligning the policy to exchange rate stability and creating long-term conditions for sustained economic growth. 

Earlier in September, IMF Mission Chief to Sri Lanka, Todd Schneider, is reported to have made a similar remark at a media conference in Colombo. He also had emphasised that Sri Lanka should not cut rates but look at tightening monetary policy in view of the rising core inflation numbers and private sector borrowings from commercial banks (available at: http://economynext.com/Sri_Lanka_should_not_cut_rates,_but_look_at_tightening_ahead IMF-3-3019-.html ). 

Independent think-tanks such as the Institute of Policy Studies or IPS and independent analysts too have questioned the wisdom of the Central Bank’s monetary policy direction in the recent past. 

For instance, IPS, in its latest State of the Economy 2015 Report has termed the current monetary policy as a ‘misalignment with the exchange rate’. (A review available at: http://www.ft.lk/article/487845/IPS-s-SOE-2015-has-delivered-a-strong-message-to-Govt--which-it-cannot-ignore--%E2%80%98Reform-or-Perish ) meaning that the present exchange rate debacle of the country is a creation of the Central Bank. 

An independent analyst writing under the penname Bellwether has cautioned that Sri Lanka’s low interest rate policy may take the country in the PIGS (Portugal, Italy, Greece and Spain) path that would lead the country to total economic bankruptcy (available at: http://economynext.com/Sri_Lanka_in_danger_of_travelling_the_PIGS_path_with_low_nominal_interest_rates__Bellwether-3-480-2.html ). 

This writer too, in a number of previous articles under this series, has questioned the appropriateness of the Central Bank’s current monetary policy obsessed with lowering interest rates and expanding credit levels to private sector. 

For instance, in an article titled ‘Central Bank’s monetary policy review: Is there a hidden macroeconomic anomaly?’ in September 2014 (available at: http://www.ft.lk/article/357157/Central-Bank-s-Monetary-Policy-Review---Is-there-a-hidden-macroeconomic-anomaly? ), this writer expressed the view that the distortion of the interest rate structure would result in an elephantine macroeconomic problem exerting pressure on the exchange rate to depreciate and putting the Government budget into a precarious situation. 

Though the Central Bank disputed this writer’s assertion at that time, evidence since then has shown that that early warning has become prophetic. The consensual view of all those economists outside the Central Bank is and was that the current monetary policy direction of the bank involving a low interest rate structure and expanded credit base is myopic.

Using loose monetary policy as a magic wand to remove structural impediments to growth

Why has the Central Bank loosened the monetary policy stance since about 2013? According to the monetary policy statements issued by the bank month after month, there have been two reasons that have prompted the bank to do so. 

One is the deceleration of inflation rate, as the bank has read the inflation numbers, in the last 15 months consecutively. This deceleration has been more pronounced in first nine months of 2015 when the Colombo Consumers Price Index recorded either a decline or remained more or less stagnant. 

The other is the need for accelerating economic growth through an expansion of private sector credit. It thus appears that the bank is of the belief that credit levels are a magic wand that would keep the economy going despite the presence of many structural impediments that stand in the way for the economy to expand output and employment. Such impediments have been demonstrated by the low ranking of the country in global competitiveness, budget openness, governance and innovation, to mention but a few. 

 

Credit expansion in an import-prone economy will worsen balance of payments   

The bank is obviously following a Keynesian-type economic policy here which advocates that an increase in money supply giving extra buying power to people would increase their total demand for goods and services thereby stimulating the supply side of the economy. Naturally, when there is a demand, it has to be met and the bank has presumed that producers would step up production to meet that demand. To increase production, producers have to utilise more natural resources and hire more people. It would automatically increase output and accelerate economic growth in multiple terms, according to this ideology. 

But the founding Governor of the Central Bank, John Exter, has cautioned those who would take the Central Bank along that path to create prosperity for people in his report to the Government recommending the establishment of the Central Bank, known as the Exter Report. 

Says Exter: “In a country like Ceylon, however, which is very dependent upon imports, in which half the productive resources are devoted to export, and which is chronically short of capital equipment, such policies would tend to raise domestic prices without producing an adequate response in domestic output. Instead, higher domestic income would stimulate the consumption of imported goods and precipitate serious balance of payments difficulties (pp 20-1).

 

Wisdom from neighbouring Singapore

Singapore’s first Finance Minister, Dr. Goh Keng Swee, too expressed the same view of Central Bank sponsored credit expansions to stimulate an economy which is dependent on external trade. 

In the 25th anniversary publication of the Board of Currency of Singapore titled ‘Prudence at the Helm’, Swee explained why Singapore opted to have a currency board instead of a central bank which can create bank credit and stimulate an economy. Says Swee: “None of us believed that Keynesian economic policies could serve as Singapore’s guide to economic well-being. Our economy was and is both small and open. Financing budget deficits through central bank credit creation appeared to us as an invitation to disaster....The way to better life was through hard work, first in schools, then in universities or polytechnics and then on the job in the work place. Diligence, education and skills will create wealth, not Central Bank credit” (p 33). 

Nation expects the Central Bank to preserve the value of its financial wealth

Therefore, the Central Bank should use its power to fix monetary policy with due care and caution. In the issue of every currency note, it has given a sacred and solemn undertaking to people. That is, the bank would take appropriate monetary policy measures to preserve its value over the time. In laymen’s language, this amounts to maintaining a virtually inflation free world over the medium to long term. 

But, what is an inflation free world? It is a situation where prices are free from pressure to change either way because all the systems and sectors in the economy are perfectly in balance and harmony with each other. Economists call this ‘macroeconomic stability’. 

 

Central Bank’s mandate is to take a holistic view of the macro economy

This fact was taken into account when the Monetary Law Act, the governing legislation of the bank, was amended in 2002 re-defining its objectives. Accordingly, instead of just saying price stability, ‘economic and price stability’ was made the bank’s co-objective. The circumstances leading to the amendment of the Act and what was meant by economic and price stability were discussed by this writer in a previous article in this series titled ‘Central Bank’s Mandate is to attain both economic and price stability’ (available at: http://www.ft.lk/article/51258/Central-Bank-s-mandate-is-to-attain-both-%E2%80%98economic--and-%E2%80%98price--stability ). 

 

Price indices alone are misleading because they can be manipulated by politicians

The true meaning of economic and price stability is as follows: A central bank’s job is not to maintain the stability of a price index but the stability of the whole economy. This is because price indices can be made stable through artificial means. 

For instance, the Government can keep the prices low by giving a subsidy, by cutting administered prices like fuel, LP gas and electricity tariffs or controlling prices. Or the worst, by manipulating the price index through such means as ‘trimming’ or taking out important consumer items from the basket. For instance, in Sri Lanka’s CCPI on which the Central Bank bases its monetary policy decisions, tobacco and alcohol are still taboos. 

 

A deceleration in the price index through artificial means is only ‘easing of cost of living’

Those artificial measures taken by a Government would surely cause a consumer price index to grow slowly thereby recording a low rate of growth. That is not deceleration of inflation, but easing of cost of living. 

However, a Central Bank cannot be happy about this development if there are imbalances in other crucial sectors in the economy, namely, the government budget, balance of payments or real growth. That is because the imbalances in these sectors can adversely affect the bank’s attempts at stabilising prices. 

It has already been shown by an acceleration of the core-inflation which is free from such price reductions to 4.7% by end October 2015. Hence, the Central Bank, in designing its monetary policy should have a holistic view of the economy rather than having a narrow view on the changes in a price index which can be manipulated by the Government to attain its political objectives at the expense of long-term growth or stability in the economy. Central banks are not owned by politicians but by the nation and, therefore, should function as apolitical organisations.

 

Government budget is in a precarious situation 

In the recent past, the Central Bank has been keeping interest rates at a low level and encouraging credit expansion by going by a price index which has been manipulated by the Government by cutting administered prices, resorting to price controls and taking important consumer items out of the basket. 

But at the same time, there have been serious imbalances in both the government budget and the country’s balance of payments that depicts the true status of its external sector. Government revenue has been falling, expenditure ballooning and budget deficit expanding. It has already missed the deficit targets for 2015. The Central Bank’s accommodation of the Government’s financing requirements has increased sharply from Rs. 5 billion at the beginning of the year to Rs. 174 billion, the latest. 

The Government has been forced to borrow on two occasions by issuing sovereign bonds in the international markets amounting to a total of $ 2 billion. Hence, the fiscal sector imbalance which is a threat to Central Bank’s economic and price stability objective has been looming over the whole country. 

 

External sector too is in a crisis

On the other side of the equation, the country’s external sector has been in a very precarious situation starting from early 2012. Exports which fell significantly in that year have not yet recovered sufficiently and in 2015 so far, it is a decline over the exports of the previous year by about 2%. 

At the same time, imports have remained stubbornly at their 2012 levels despite the relief given by the decline in the fuel prices in the world markets. Thus, the trade deficit has remained around $ 8 billion throughout. 

Since the country has been financing its current account deficit primarily through external borrowings, it has not been able to repay the country’s loan commitments or pay interest on past foreign loans without re-borrowing from the external markets. The investments by foreigners in Treasury bills and bonds have fallen from $ 4.5 billion a year ago to $ 2.1 billion, the latest, causing foreign reserves to fall from $ 8 billion to $ 6.7 billion. 

On top of this, the loan repayment commitments and interest payment obligations over the next 12-month period have shot up to $ 4.4 billion as against a cash reserve of $ 5.9 billion. This emerging fragile external sector has forced the Government to raise $ 1.5 billion from international markets recently. Despite that, the pressure for the exchange rate to depreciate is mounting. 

 

Alarming developments in money supply and credit levels which the Central Bank cannot ignore

The deceleration of the Colombo Consumers Price Index in the last 10-month period is a technical achievement and not the outcome of balancing total demand with total supply. It has certainly relieved the cost of living of people but it has done so by creating significant holes elsewhere in the economy. 

Hence, given the above imbalances in the government budget and the external sector, the Central Bank cannot be complacent about the emerging monetary conditions of the country. 

By end-August 2015, the narrow money supply consisting of currency and demand deposits held by public has increased annually by 20%, while broad money consisting of narrow money plus time and savings deposits of the public has increased by 17%. 

Meanwhile, the reserve money base of the Central Bank that would be used by banks to create multiple deposits and credit over the next 18 months or so has increased sharply by 20%. 

Private sector credit too is rising at an annual rate of 20-23%. All indications are that Sri Lanka is heading toward a serious macroeconomic crisis in the period to come. Its monetary policy action would further be complicated when the Government uses the proceeds of the recently borrowed $ 1.5 billion to finance its expenditure programs. That is not small sum but well over Rs. 210 billion. 

It would cause the Central Bank to buy those dollars and release rupees, augmenting the already high excess market liquidity on one hand and raising the reserve money base to uncontrollable levels, on the other.  With the current low interest rate policy, the bank would not be able to resolve the problem without losing its reputation. 

 

The good physician Central Bank giving sugar to a diabetic

Thus, the Central Bank which is the physician charged with the task of curing the macroeconomic ailments through its monetary policy should take an apolitical and objective policy stand. It requires the bank to increase interest rates and not cut interest rates further in order to curtail the credit levels in the economy. 

This is a painful action but that is what the bank is expected to do in such a situation. To attain its objective, it has to get the full cooperation of the new Good-Governance Government.

 

Minister of Finance should not frighten international investors

In this background, it is disheartening to note the announcement made by the Minister of Finance, as reported by Reuters in a report datelined from London on 29 October 2015 that the minister wants the Central Bank to cut interest rates to a level of 4-5%. 

One can understand the predicament of the minister who is desirous of having a high growth rate which is, according to the estimates of IMF, to fall to a level of 5 to 5.5% this year. But reducing the interest rates at this juncture is similar to giving an additional sugar dose to a diabetic who already has high sugar levels in his blood. Such public announcements made by the minister also undermine the independence of the Central Bank and its position among global market participants. 

Investors outside the country rely, not on the sovereign government, but on the Central Bank for taking appropriate and timely policies to safeguard their interests in the country. That assurance will be given by a Central Bank functioning, in their eyes, as an institution free from narrow political interferences. 

Sri Lanka cannot function like an island separate from other nations anymore, since foreign investors have stakes in the country in a big way today in the form of their investments in domestic Treasury bills and bonds and global sovereign bonds. Any political manipulation of the monetary policy will give a temporary relief to the Government but frighten away existing as well as prospective investors. 

 

Wisdom of Goh Keng Swee comes in handy

At a time when independent analysts have found fault with the Central Bank for not increasing interest rates, such a Government-sponsored reduction in the rates will totally be counterproductive. 

Perhaps, Sri Lankan politicians can learn from the wisdom of Dr. Goh Keng Swee, who has justified the action taken by early Singapore leadership to assure international markets. Says Swee: “Our intention was to inform the financial world that our objective was to maintain a strong convertible Singapore Dollar. This remains the best protection against inflation.” (p 34).  

(W.A Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected] )