By W A Wijewardena –

Dr. W.A Wijewardena

Taking the digital platform to share experiences

With the increased cost of printing, many writers have turned to publishing e-books. They have a better storage facility in the clouds and offer a wider outreach anytime in any part of the globe. Cost-wise also they are economical for both the writer and the reader. The latest to join this bandwagon has been the ex-central banker, C.A. Abeysinghe, who has released his e-book on ‘Unveiling the Secrets: How money is created?’ recently. Anyone interested in downloading the book for reading can have it from the Ruhuna University Library Catalogue click here. The book, based on Abeysinghe’s long experience at the Central Bank, first as an economist and later as the man in charge of the implementation of the monetary policy, is timely. That is because though many speak of the Central Bank’s money printing power, their understanding of the subject at a deep level seems to be limited. Hence, Abeysinghe’s book can be used by those interested in monetary economics as a primer.

Complexity of money creation

C.A. Abeysinghe

Abeysinghe has justified the purpose of writing the book in the preface as follows: “My goal in this book is to offer a thorough exploration of the complex money creation process in a single attempt by blending more practical aspects of monetary management. However, it does not include any research findings or economic analysis. The book comprehensively discusses different types of market transactions and the monetary tools employed by the Central Bank of Sri Lanka, including open market operations, standing facility, and statutory reserve requirements. It explains concepts related to money creation, such as bank reserves, excess reserves, excess liquidity, statutory reserve ratio, Central Bank balance sheet, etc., making them accessible to the average reader”. The book is, therefore, for the ordinary layman who has no previous training in economics.

Opening the black box

Money printing is a mystery and shrouded in a black box. Abeysinghe has opened this black box for us in 10 chapters. Many believe that money printing refers to Central Bank’s printing of physical notes and minting of metallic coins. They are directly issued to the public for use in transactions. However, this is only a part of the story. As Abeysinghe has correctly put it, “money creation primarily involves the central bank initiating the process by crediting the accounts of commercial banks with the Central Bank”. It is much more than what is visible to the naked eye.

Abeysinghe unravels this complex operation, one by one, for the ordinary readers. Though it is initiated by the Central Bank by creating what is known as ‘reserve money’, ‘base money’, or ‘monetary base’, the actual work is done by commercial banks through their power to create multiple deposits and credit.

Reserve money is the ‘seed money’

Reserve money represents all those liabilities of the Central Bank which it must discharge in money terms by paying back in money – known as monetary liabilities – to outsiders except the Government. For instance, a currency note which you possess is a monetary liability of the Central Bank. You can get its value at any time by surrendering to the Central Bank. In good old days, the Central Bank paid its value by giving you a certain amount of precious metal – gold or silver. But today, the central banks do not have stocks of gold or silver. Therefore, today, they take your currency note and give you another currency note. This is known as a sight liability of Central Bank since the bank is required to give that new currency note on seeing the old note which you have surrendered to it.

But a demand deposit which the Central Bank maintains for a commercial bank in its books – another monetary liability – is paid back on demand when the bank concerned makes a written request to the Central Bank. The Central Bank may pay it by issuing a currency note – in which case the currency liability of the bank will increase – or by debiting that bank’s account and crediting another bank’s account. The Central Bank creates this reserve money just by making book entries and supplies to commercial banks as ‘seed money’ to facilitate them to create further money in multiple terms. Abeysinghe has described this process in lucid terms in the book.

Seed money leads to multiple money creation

Says Abeysinghe: “The Central Bank is at the centre of the money creation process, working in conjunction with commercial banks. By utilising tools such as standing facilities, open market operations (OMOs), policy measures like policy interest rate adjustments, and regulations such as reserve requirements, the Central Bank aids commercial banks in creating money”. All these arise from the third tool which Abeysinghe has called the reserve requirement. In this tool, the Central Bank will require all commercial banks to maintain a cash reserve as a deposit in its account with the Central Bank as a percentage of their deposit liabilities.

For instance, if a bank has accepted a deposit of Rs. 100 from a customer and the reserve requirement fixed by the Central Bank is 10%, the commercial bank should always have Rs. 10 in its account with the Central Bank. Since this is fixed by the central bank by law, in terms of the now repealed Monetary Law Act or the newly introduced The Central Bank of Sri Lanka Act, it is known as the Statutory Reserve Requirement or SRR. If a particular commercial bank has more than Rs. 10, it has excess liquidity and less than Rs. 10, it has deficit liquidity. Since the commercial bank should pay interest to customer, it is not profitable for it to keep excess liquidity as idle money.

It can first lend this excess liquidity to another bank which has a deficit in an overnight market called the Inter-bank call money market. The excess bank will require the Central Bank to debit its account and credit the account of the deficit bank in the books of the Central Bank – a way of discharging the monetary liability of the Central Bank. If the market evens out the excess liquidity and deficit liquidity of commercial banks, then the process outlined as the use of standing facilities by Abeysinghe does not come into picture. It comes into operation if there is still excess liquidity and deficit liquidity within the banking system.

Standing facilities should prevent ‘arbitraging’

There are two standing facilities offered by the Central Bank. One is called the Standing Deposit Facility or SDF available for banks which have an excess of liquidity after lending in the interbank call money market. Those banks can temporarily deposit their excess money with the central bank at an interest rate fixed by the bank as the Standing Deposit Facility Rate or SDFR. Since banks are required to lend their customers, this should naturally be low enough to discourage them to use it as a habit but providing them a minimum rate of return. Therefore, it should also be lower than the prevailing call money rate.

The other facility is called the Standing Lending Facility or SLF which can be used by banks to fill the required liquidity if they find it impossible to meet it by borrowing from the call money rate. Since banks are required to build their deposit base, this rate should be sufficiently high enough to discourage them to borrow from the central bank and lend in the call market or putting their borrowing in government Treasury bills or bonds. Hence, these two facilities are offered by the Central Bank to facilitate commercial banks to run their operations smoothly with sufficient liquidity and not to run banking business on a permanent basis.

Since this type of lending by the Central Bank leads to the creation of reserve money and through it, further money creation by commercial banks, this lending window should be kept at a minimum within the overall money supply targets of the Central Bank. What should be prevented is the ability of commercial banks to borrow from the Central Bank at low rates and invest in high earning instruments, a practice known as ‘arbitraging’ in the banking parlance. Abeysinghe has given details of how these two systems operate in practice.

OMO is the ‘monetary policy tool’

The open market operations or OMO are quite different from SRR and the two standing facilities. It is directly related to the Central Bank’s money supply and inflation targets. Since the reserve money within the system is the main seed or ingredient for commercial banks to create multiple deposits and credit, OMO is used by the Central Bank to take out the excess liquidity within the system – called syphoning off the excess liquidity – that will be above the reserve money target. The Central Bank will do so by selling the Government securities it comes to own from previous lending to the Government either as outright sales or temporary sales in the form of REPO or repurchase transactions.

The operation of the REPO system for monetary policy purposes is not normally understood by many students of monetary theory. This is the only market driven policy instrument since it is the market that determines interest rates at auctions. However, the Central Bank can influence the market rates through its arbitrary decisions on the timing of the auction, volume offered, and the amount accepted. Though Abeysinghe has not said it, the normal procedure adopted by the Central Bank is to centre it around its policy rates – the so called standing facility rates – which are a distortion due to its arbitrariness of the choice of the rate levels and the unseen hand in satisfying the political masters. Abeysinghe has introduced them briefly in Chapter 2 and explained in detail in the subsequent chapters.

REPOs and reverse REPOs

In short, a repurchase or a REPO is a sale of an asset to another with a promise to buy it back on a future date at an agreed price. This is the seller’s side. A mirror image of this from the buyer’s side is called a reverse repurchase or R-REPO in which the buyer will buy the asset for a temporary period with a promise to sell it on a future date at the agreed price. Suppose I do not need my car tomorrow, but you need a car for your use just for one day. You and I can get into a REPO transaction here. I sell my car to you for Rs. 100 today to buy it back for Rs. 90 tomorrow. For me, it is a REPO but for you it is a reverse REPO.

I get Rs. 100 today which is your expenditure for the car. You will use the car tomorrow and sell it back to me for Rs. 90. My expenditure and its mirror image, your income is Rs. 90. The difference between the two transaction prices amounting to Rs. 10 is my income and your expenditure for use of the car for one day. I am willing to part with my car for Rs. 10 for one day because I do not need it tomorrow. You are willing to pay Rs. 10 for that facility because it is your hiring charge for the car for a day. Hence, repurchase transactions and their mirror image, reverse repurchase transactions, can happen for any asset and not necessarily for a financial instrument. It would have been better had Abeysinghe introduced these two concepts in this fashion to help the reader understand them better.

Taking the reader through practice

In the rest of the book, Abeysinghe has taken the readers through a detailed analysis of how these instruments are used with examples of different levels of balance sheets of both the Central Bank and commercial banks. A balance sheet in which assets are equal to liabilities can be presented in the form of an equation at the aggregate level. The manipulation of that equation will produce different types of policy parameters for authorities. They can be solved for different money and reserve money aggregates; on the left-hand side of the equality sign, we have the money supply or the reserve money aggregate and on the right-hand side, we have the factors that affect those aggregates. Abeysinghe has presented those results in tabular form with numerical illustrations for readers to understand them fully. If a reader follows them carefully, he will be able to apprise himself of the entire mechanism underlying the process and demystify the mystery. That has been the purpose of producing this primer by Abeysinghe.

Connection between the textbook analysis and practice

But what we find in the traditional textbooks is different from them. Abeysinghe has explained this textbook analysis too in detail in the primer. This will enable students of monetary policy to connect the textbook analysis with what is happening in the Central Bank which in most respect is a black box not easy to comprehend. That is the beauty of the work done by Abeysinghe.

Abeysinghe’s work is commendable

Abeysinghe who has practical experience in monetary policy designing, inflation number compilation, and operationlising the monetary policy deserves our commendation for the work he has completed as a retired officer of the Central Bank. However, I would have loved a more attractive title page, a back cover with a suitable blurb, and an index to the book at the end. The present title page with tables, numbers, and various incomprehensible key words is scary and dims the mood of the reader. A good back cover is the instant promoter of reading. An index will help a reader to look for a particular key concept without turning all the pages. These are not difficult to do even now since it is an e-book.

These trivial lapses do not diminish the value of the book. I recommend it to all those readers who are interested in having a demystification of the black box operations relating to monetary policy in the Central Bank and money creating within the monetary system of a country.

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com