By W A Wijewardena –
After the former Central Bank Governor and State Minister of Finance Ajith Nivard Cabraal took over the helm of the Central Bank two weeks ago, there was a definite change in the tone and the choice of words he used when talking about the Government’s economic policy program. This was quite obvious in the two interviews he gave, one to Bloomberg News and the other to Derana TV, immediately after he returned to the Central Bank.
Previously when he was the state minister, he was openly not for an IMF style economic bailout, worshipper of Modern Monetary Theory or MMT more than some of its advocates, and a believer in the success of import, exchange, price, and interest rate restrictions to take the economy out of the catastrophic debt, forex and growth problems with which the country was facing.
He publicly declared that money printing did not cause inflation or exchange rate depreciation. I dubbed this economic policy as Cabraalnomics in one of my previous writings. As State Minister of Finance, he had the luxury to say so.
A Governor should be a Governor
But as the Governor of the Central Bank, he should now be a fully-fledged central banker. This is typical of all those who come to a central bank from outside. For instance, in the neighbouring India, the fiercely independent RBI Governor Y.V. Reddy was replaced by the government in 2009 by the Joint Secretary of the Ministry of Finance, Dr. Duvvuri Subbarao, who was expected to be a mouthpiece of the government at RBI. But soon, he got converted to the good practices of central banking and became more independent than even his predecessor.
As recently as last week, in an interview with The Economic Times, he recommended to the cash-strapped Indian government the sale of the partly owned government assets under public private partnership programs and generate cash for infrastructure development. This process is known as ‘asset monetisation by the government’ and similar to Sri Lanka’s planned sale of land and other properties under its Helandiva scheme. He did not recommend money printing for this purpose.
Taking a similar line, in the two interviews mentioned above, Governor Cabraal has moderated his previous hard stance and showed the signs of making a U-turn by speaking like a central bank head. This is an encouraging development.
An apparent U-turn by Governor Cabraal
In summary, in the two interviews he said that he will reverse the aggressive money printing done by the Central Bank in the past by asset purchases which was nothing but lending to the Government by buying Treasury bills, review the efficacy of the low interest rate policy with a view to increasing the rates, do away with the price controls as a mechanism for easing the cost of living of people, and manage the exchange rate proactively. All these, he said, will be done without causing pain to the economy.
But he abstained himself from giving a direct answer to the question whether the Central Bank would recommend to the Government that it should seek the assistance of IMF to come out of the present balance of payments problems. But this is also a moderation of the previous hard negative stance he had about going to IMF.
However, to make matters easy for Governor Cabraal, the de facto economic policy leader of the Gotabaya Rajapaksa Administration, President’s Secretary Dr. P.B. Jayasundera in an interview with EconomyNext has said that IMF had a role to play in Sri Lanka’s present forex crisis when the Government had formulated the necessary policy framework. This is also a U-turn because previously he is reported to have said that IMF was not the solution for Sri Lanka’s economic ills.
It seems that the job of Governor Cabraal is to prepare this policy framework on behalf of the Government for submission to IMF. He may be presenting a blueprint of this policy framework in the interim road map he is to announce on 1 October. To distinguish from his previous stance which I now redesignate as Cabraalnomics 1.0, the present policy stance is dubbed as Cabraalnomics 2.0.
A mixed track record
When compared with the loud promises he made, Governor Cabraal’s track record so far has been mixed. He has made a certain headway with respect to interest rates. But his proactive exchange rate management has been the pursuit of the same fixed exchange rate system introduced to Sri Lanka by the former Governor Lakshman, which I called the Lakshman Shock.
Low interest rate policy and its implications
Treasury bill and bond rates had been brought down and kept low by Governor Lakshman to facilitate the Government to borrow cheaply. The corollary has been the inability of the public debt authorities to raise the full amount they had offered in the market. The unmet gap had to be purchased by the Central Bank leading to an unprecedented increase in its Treasury bill holdings. For instance, as at end-2019, the Treasury bill holdings of the Central Bank amounted to Rs. 75 billion. This figure rose alarmingly to Rs. 1,332 billion by the third week of September 2021.
Typically, this would have caused an explosion in the reserve money base of the country, the seed money produced by the central bank and used by commercial banks to create further money. However, the reserve money base increased but at a moderate rate due to an unprecedented outflow of foreign exchange from the country. This is evident from the sharp decline in the net foreign assets of the Central Bank from Rs. 896 billion at end-2019 to mere Rs. 10 billion by end July 2021, the latest date for which the relevant data are available.
This was bad enough but another development that took place along with it made it ominous. That development was the sudden increase in the ability of the banking system to create new money – known as the money multiplier – from 8 at end-2019 to about 10 by July 2021.
What this means is that every rupee created by the Central Bank by way of accommodating the Government and through other operations had ended up in creating 8 more rupees in the system previously, but it would now create Rs. 10, an ominous development for a stability-conscious central bank. This was evident by the increase in the money stock during this period by Rs. 2.7 trillion or 35%. But with the higher money multiplier at end-July 2021, the growth in the money stock in the next 12-to-18-month period will be more.
Apparently, having realised the oncoming danger, Governor Cabraal has started freeing the Treasury bill market from the grip of the Bank in the very first auction held under his leadership. Accordingly, at the auction held on 22 September, yields were permitted to rise by a small shot of about 0.3-0.38% or 30-38 basis points. Since it was a small shot, he still could not raise the full amount offered to investors from the market. Accordingly, the unmet gap of Rs. 19 billion had to be purchased by the Central Bank causing ‘money printing via asset purchase’ which Governor Cabraal said confidently to Bloomberg News that he would reverse.
The continued arm-twisting in the forex market
Contrary to this, in the forex market, his intervention took the form of further strengthening of the Lakshman Shock which had sought to fix the rupee/dollar rate at Rs. 203 by twisting the arm of bankers. As I have argued in my article on this subject mentioned above, this policy had caused dollars to disappear from the market, a vibrant and more dynamic black market to appear, and exporters and immigrants to shun the formal banking system.
Instead of freeing the market from these crutches, the Central Bank under Governor Cabraal’s leadership has issued a confidential warning letter to CEOs of banks that they should strictly adhere to the limits given in the Lakshman Shock by enforcing the regulation on both exporters and importers. This is untypical of Governor Cabraal who had been raised and trained in the private sector and who had held that post previously. He should have known that unless the Central Bank was prepared to supply an unlimited amount of dollars to the market, commercial banks cannot hold on to the fixed rate of Rs. 203 per dollar. The result was the lengthening of the queue for dollars and the expansion of the black market further.
Arbitrageurs to the rescue
A hypothetical case can be presented here for Governor Cabraal’s attention. Suppose there is a Sri Lankan returning to the country with a bundle of crisp US dollars, say about $ 10,000. Will he sell those dollars to a bank at Rs. 199 as fixed by the Central Bank? Unlikely when he knows that there is a black market that would buy his dollars at Rs. 225-30. This price information and the availability of dollars are spread quicky throughout the market via modern communication methods.
Suppose there is a man in Kandy who wants to send his son abroad for further studies and his flight is due to leave Colombo the very same night. His bank has told him that he must wait for about three weeks to get dollars at Rs. 203. Under this situation, the desperate man is willing to buy dollars at any price. This information too is publicly available. It prompts an enterprising arbitrageur to travel to Colombo, buy those dollar bills at Rs. 230 per dollar, and deliver them to the desperate father at Rs. 260.
Both the seller of the dollar bills and the arbitrageur are benefitted in this transaction. The seller gets a margin of 14% over the Central Bank’s promised rate. The profit margin of the arbitrageur when annualised comes to a thumping 4,500% after deducting his travel costs to Colombo. What about the buyer? He can send his son abroad in the scheduled flight in the same night. In this instance, the black market has been more efficient than Governor Cabraal’s official market in meeting the aspirations of both buyers and sellers.
When such a dynamic black market is operating, the power of the Central Bank as the forex regulator is shrunk completely, and the letters it may address to the bankers may not be worth even the papers on which they are written.
Avoid reaching the tipping point
Unlike Governor Lakshman who was a pure academic, Governor Cabraal who has come from the private sector is well aware of this ground reality. The longer he hangs on to the Lakshman Shock, the greater the damage he is causing to the economy. When the damage reaches its tipping point, as highlighted by Malcolm Gladwell in his bestselling 2000 book by the same title, it will be catastrophic and difficult to be reversed. Gladwell has cogently argued that an unattended endemic soon develops into an epidemic and then to a fully blown pandemic tipping the system in an irreversible manner.
His advice? Do not allow small and trivial things to accumulate because in a system they grow in multiple terms like the still rising money multiplier which Governor Cabraal must grapple with now. The country’s forex problem has now been blown to a pandemic level, a much more dangerous pandemic than the present COVID-19 pandemic. Therefore, his treatment of forex pandemic in Cabraalnomics 2.0 should necessarily be aligned to be consistent with other bold policies he is planning to adopt.
Eradication of Ha-Joon Chang virus
There is another virus which Governor Lakshman has left in the Central Bank and Governor Cabraal should now eradicate. Otherwise, these small things will blow themselves up into mega pandemics reaching the tipping point. That virus is the dogma associated with his anti-neoliberalism and anti-IMF stance supported by Modern Monetary Theory which he had attempted to install within the Central Bank. His supporters brought from outside to serve on numerous committees in the Bank were arguing, like the State Minister Cabraal had done in Cabraalnomics 1.0, that money does not cause inflation and inflation does not cause currency depreciation.
He had talked extensively about an alternative economic policy which was known only to himself. The latest virus he had tried to install in the Bank happened to be the 71st Commemorative Oration of the Bank that was conducted via Zoom recently. He had invited his longstanding friend and intellectual ally, the Cambridge economist Ha-Joon Chang to deliver this oration. The topic assigned was ‘Why Sri Lanka needs structural transformation and what can the Central Bank do to help it?’
Of the 59-minute-long lecture, he came to his topic only in the 53rd minute. His recommendation was that Sri Lanka should go for structural transformation by bringing in high technology, high skills, and better management techniques. He said that this should be led by the Government and not by the private sector. But the private sector can be brought on board by going into ‘productive private public partnerships’.
According to him, the Central Bank should be an active agent in this transformation. But the bank should be free from the ‘narrow short-term oriented and the rigid view of central banking dominated by decades-long neo-liberalism which has been a detriment to structural transformation and long-term development’. He had failed to establish that the Central Bank had been adopting neo-liberalism and how it had been detrimental to structural transformation and long-term development.
He should have been advised that during the whole of its post-independence history, Sri Lanka had attempted to introduce high technology, high skills, and better management techniques through government intervention and not through the private sector.
In most cases, the private sector had been a yielding hand to this initiative. In a few cases where the private sector had broken away from the Government crutches, the story had been a success. I recall that in the past when such a virus was introduced to the Bank by an outside academic, its Economic Research Department went into a full analysis of same to prevent its multiplication and thereby taking the Bank to its tipping point.
Cabraalnomics 2.0 will be announced formally in October 2021. However, if he does his reforms only halfway through, the likelihood is that it will also be a failure like the Lakshman Shock. It behooves Governor Cabraal to avoid this pitfall.
*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com