By W.A Wijewardena.
Three moves made by the Central Bank in the recent past have been tantamount to an open admission that Sri Lanka is in a deep economic crisis. Of course, the crisis, as this writer had pointed out on numerous occasions, was not the creation of this Government, but something which it had inherited from the previous administration.
Yet, this Government is at fault for making several mishaps by itself: Not making a proper assessment of the economy despite the warning by independent analysts; signing off the inflated growth numbers produced by the previous administration in the reports it has put out; not disclosing the crisis to prepare people for hard choices and failure to take immediate corrective action to come out of the crisis. Now the crisis is looming large over the country calling for firm action. But the authorities appear to be taking palliative measures to fix it.
The ‘resilient’ external sector forcing the Central Bank to allow the rupee to ‘depreciate’
The first move was to allow the rupee to depreciate in the foreign exchange market after many unsuccessful attempts at defending the rupee by losing the foreign reserves belonging to the nation.
Although the external sector had continued to deteriorate as from around 2009, the Central Bank Annual Report 2014, published in April 2015, had reported to Parliament that “Sri Lanka’s external sector improved its resilience in 2014 with a narrowing of the external sector imbalance and a surplus in the overall BOP”. The word ‘resilience’ is a misnomer here because its meaning connotes something else: Resilience, as related to an economy, means that once the economy has fallen due to an external pressure or an internal implosion, it would rise up again on its own without outside support. But six months after giving the good certificate to the economy, the Central Bank had to abandon the use of the country’s foreign reserves in the defence of the rupee in the exchange market.
Accordingly, the rupee fell from Rs. 131 per US dollar at the beginning of 2015 to Rs. 145 per US dollar by the fourth week of December 2015. This is a depreciation of 10% over the year.
The use of an abandoned monetary policy weapon by the Central Bank
The second move was to commence tightening monetary policy as from 2016. In the latest monetary policy announcement, the Bank said that it would increase the Statutory Reserve Ratio or SRR by 1.5 percentage points to 7.5% to be effective from 16 January 2016. The reason? There is a high excess liquidity in the money market and it should not be allowed to continue to prevail because it would increase future inflation by increasing money and credit.
This excess liquidity is not a new phenomenon and the market had been flooded with excess liquidity for many months. All the time, the Central Bank took the opposite view and encouraged commercial banks to increase their credit levels by even reducing interest rates.
Placing responsibility for requesting IMF support on PM
The third move, first announced by Prime Minister Ranil Wickremesinghe in Parliament earlier in December, is to seek the support of the IMF to get out of the current foreign exchange crisis through a new financing arrangement.
So far, the Government has not approached the IMF for such an arrangement and it says that it would do so in February 2016, when the next IMF mission is fielded to Sri Lanka. Announcing this intention in a recent media briefing, Central Bank Governor Arjuna Mahendran implied that it is a move coming from the Prime Minister and not from the Central Bank or the Ministry of Finance, the two institutions that should make this request together to IMF.
Market-based monetary policy weapons
In the latest monetary policy tightening, the Central Bank has used SRR which was a weapon that had been abandoned by the Bank many years ago as unsuitable. The Bank had chosen to implement its monetary policy through market-based weapons because they did not bring about irreversible market distortions.
Accordingly, the Bank had gone for changing its policy interest rates directly, first used as REPO and Reverse REPO rates and later changed to standing deposit facility rate and standing lending facility rate, respectively.
The former is a measure to take away the excess liquidity in the market by accepting it as a deposit with the Central Bank by paying interest at the rate of 6% per annum. Hence, it is a cost to the Central Bank and such interest payments, amounting to Rs. 18 billion in 2014, happened to be the largest single expenditure item of the Central Bank in that year. Hence, if the excess liquidity is higher, the Central Bank’s interest expenditure will also be higher. But under the new SRR, a minimum of additional Rs. 50 billion has to be kept by commercial banks in the Central Bank without earning any interest income. Thus, the new monetary policy tightening will pass the cost from the Central Bank to commercial banks.
SRR is a dead duck
SRR has been abandoned by central banks as an unsuitable monetary policy weapon with the exception of a few central banks like the US’s Federal Reserve System and China’s central bank which still rely on it. There are many reasons by other central banks, including the Central Bank of Sri Lanka, for considering it as an unsuitable monetary policy weapon.
Imposing an unintended tax on banks
First, it is a tax imposed on commercial banks because banks are forced to keep their hard-mobilised deposits in idle form at the Central Bank. In the present situation in Sri Lanka, banks pay on average about 6% on their deposits and spend another 2% in mobilising and maintaining those deposits. If they add a profit margin of 2% to that cost, their opportunity cost amounts to about 10% per annum.
Hence, when these moneys are kept in idle form in the Central Bank, banks lose about Rs. 5 billion per annum which is a tax on them. It is a ‘deadweight tax’ since it is a loss to banks but no one else in the economy earns it as revenue.
Forcing banks to increase interest margins
Second, SRR brings in an unintended consequence in the form of widening the gap between banks’ deposit rates and lending rates, known as the interest margin. Since banks have been forced to keep their deposits, mobilised at a cost, in idle form with the Central Bank, they have all the incentive to recover it from their customers.
The strategy they adopt to attain that goal has been to punish both depositors and borrowers. They would accordingly reduce deposit rates or increase lending rates or do both. Whatever the strategy to be adopted, it widens the interest margin, an index of inefficiency of the banking system of the country and an ailment which the Central Bank has been fighting very hard to eradicate.
Long time lag in yielding results
Third, SRR becomes effective in delivering the objective of taming money and credit growth after a long time lag. Hence, it defeats the Central Bank’s announced goal of fighting inflation in the next 6-12 month period.
The increase in SRR is an external shock delivered on banks and not on markets. Hence, banks are required to make a series of adjustments to change the size of their loan books and it takes time for that process to run its full course.
From the middle of January, banks will have to park an additional Rs. 50 billion with the Central Bank. Those banks with excess liquidity can do so without any labour because they have excess funds to do so.
However, banks with deficit liquidity will have to borrow immediately in the call money market to meet the new obligation and it will dry up the moneys in the call money market. If funds are not available in the call money market, banks would be forced to sell some of the Government securities they are holding by pushing down the price and increasing the yield rates. It will affect the government securities market in the form of increasing all yield rates across the board. Banks would be forced to cut their lending only after that and experience shows that it takes about 12 to 18 months for the full cycle to run its course.
Forcing banks to abandon core banking business
Fourth, it is not a market oriented policy weapon since it is in effect a tax on banks and brings about a series of market distortions which the Central Bank would not love to have in the system. A few of such distortions would be, as shown earlier, widening of the interest margin, incentive for banks to move from interest based core-banking to fee-based service banking, unintended increase in the yield rates of government securities.
Of them, the shrinking of the core banking portfolio in banks will act counter to the wish which the Minister of Finance announced in the Budget 2016 to increase their core banking portfolio by restricting leasing activities.
Markets eventually increase interest rates
The Central Bank Governor in an interview with Reuters has said that the Central Bank used SRR to tighten monetary policy, since an increase in the Bank’s policy interest rates leading to an increase in the whole interest rate structure would impede economic growth.
It is true that SRR will not increase interest rates immediately and the Governor will be happy for a brief period. But, as pointed out above, it will lead to an increase in the whole interest rate structure over the time plus bring in many more unwanted consequences to the economy.
Hence, officially interest rates are not increased but the market will take action to do so defeating the Governor’s objective. In this sense, it appears that the Governor and the Monetary Board have been misinformed by their advisors.
A too short and too late policy move
The Central Bank cannot continue to increase SRR in order to further tighten monetary policy when the emerging situation demands it to do so. It is widely speculated that the US Federal Reserve Bank will implement a second round of interest rate increase in February. With the low interest rate regime prevailing in Sri Lanka, the rupee is already under pressure to depreciate because low interest rates encourage imports, give incentives for exporters to keep money out and reduce the potential capital flows.
The country is so far fortunate because it still has in its short term funding base about $ 2 billion invested by foreigners in Treasury bills and Treasury bonds down from $ 4.5 billion a year ago.
These investments have come to Sri Lanka due to the near zero interest rates prevailing in USA as against high rates offered by Sri Lanka to them. If the Federal Reserve increases its interest rates further in February, to prevent these dollars flying out of the country, the Central Bank will be forced to make a matching interest rate adjustment upward. Hence, the euphoria enjoyed by the Central Bank’s management that it has tightened monetary policy without impeding economic growth appears to be very short-lived. Thus, the policy measures taken by the Central Bank to avert the crisis are too short and too late. A policy like increasing SRR is unproductive too.
The ‘resilient’ economy has recorded a decline in growth rate in 2015
It is, therefore, advisable that the Central Bank should take a realistic view of the present state of the economy. The Bank’s Annual Report for 2014 has expressed satisfaction about the present state of the economy in its opening sentence as follows: “In 2014, the Sri Lankan economy showed the resilience in the face of domestic as well as external challenges. Real GDP grew by 7.4% in 2014, in comparison to the growth of 7.2% in 2013”.
Once again, the use of the popular word ‘resilience’ is a misnomer since it implies that the economy would rise again without external support. Strangely, the resilient economy has grown only by 5% in 2015 as revealed by Governor Mahendran at a media briefing on 31 December 2015 and according to him, it was also a “testimony to the resilience of the Sri Lankan economy”.
Take a lesson from independent critical analysts
While the Central Bank has been jubilant over economic growth and other macroeconomic numbers, The Institute of Policy Studies or IPS, another organ of the Government, looked at them from a different perspective.
In its State of the Economy 2015 Report, IPS has said that the headline growth numbers and impressive infrastructure facilities have masked the real situation in the country. Says IPS: “These (headline growth numbers and impressive infrastructure) masked some inherent structural weaknesses in Sri Lanka’s public investment led and external debt financed growth. As noted in Sri Lanka State of the Economy 2014 report ‘beyond the immediate headline macroeconomic numbers, the Sri Lankan economy continues to show skewed growth, high level of external indebtedness, modest export earnings growth and limited private sector appetite to expand the capacity’. Stacked against headline statistics, structural weaknesses in the economy, however, are not as readily explainable on election platforms”.
Not only at election platforms, such structural weaknesses in growth cannot be even explained to people in power who always desire to listen to only good news praising their policies. It is unfortunate that the Central Bank, created by the nation to give impartial and apolitical analysis to the public and make its policies independent of politics, acts like an organ pleasing the ruling political powers.
Dr. N.M. Perera’s advice to Central Bank: “Be impartial and objective”
The Central Bank management should keep itself constantly reminded of a piece of wisdom which Dr N.M. Perera, the left-wing Minister of Finance during 1970-75, left with its senior management in 1971.
At a function bidding farewell to Mr. J. Thyagaraja, retiring Monetary Board Member, N.M. Perera had advised the senior officers of the Bank that the Bank ‘should make independent reports on economic subjects to the government and not report merely to suit the political complexion of the government in power’ and that ‘he would value reports (of the Bank) made dispassionately and objectively’.
Create an ‘independence culture’ within the bank
In his economic policy statement, Prime Minister Ranil Wickremesinghe has said that the Government would take action to restructure the Central Bank so that its officers can work independently.
This is a laudable goal. But, legal independence in the Central Bank is necessary but not sufficient. What is necessary and sufficient for the Bank to carry out its mission successfully is legal independence supported by an ‘independence culture’ within the Central Bank
– FT