Paradox in Central Banks monetary

policy: Not everyone approves of the

policy direction

Monday, 2 November 2015

IMFs Resident Representative for Sri Lanka and the
Maldives, Dr. Eteri Kvintradze
Wrong monetary policy direction of the Central Bank
The IMFs 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 Lankas
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 mediumto 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
Banks 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-SOE2015-has-delivered-a-strong-message-to-Govt--which-it-cannotignore--%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 Lankas 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_PIG
S_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 Banks current monetary
policy obsessed with lowering interest rates and expanding credit levels to
private sector.
For instance, in an article titled Central Banks monetary policy review: Is
there a hidden macroeconomic anomaly? in September 2014 (available
at: http://www.ft.lk/article/357157/Central-Bank-s-Monetary-PolicyReview---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 writers 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 importprone 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
Singapores 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 Singapores 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 laymens 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 Banks 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 banks 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 Banks Mandate is to attain both economic and price stability
(available at: http://www.ft.lk/article/51258/Central-Bank-smandate-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
banks 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 Lankas 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 banks 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 countrys 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 Banks accommodation of the
Governments 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
Banks 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 countrys 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 countrys
loan commitments or pay interest on past foreign loans without reborrowing 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 10month 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 waw1949@gmail.com )
Posted by Thavam