By W.A Wijewardena –
The Central Bank: Easing the monetary policy is the best
Sri Lanka’s Central Bank cut its two basic interest rates last week – its REPO rate or Repurchase rate that it uses to crunch the excess liquidity in the market and its Reverse REPO rate used for pumping money to the system to stimulate the economy – by historic half a percent. Accordingly, REPO rate now stands at 7 per cent per annum and Reverse REPO rate at 9 per cent. The Bank in its press statement has said that it has taken this measure “to stimulate the domestic economy, particularly in the light of the gradual moderation in headline inflation and subdued demand pressures in the economy”. The Bank has also claimed that it could now push the economy back to a high growth path by increasing money but without permitting the inflation to raise its ugly head once again. The Bank has named this extraordinary skill as ‘policy maneuverability’ which means that it can increase money supply adequately to promote growth but it also can cut that money supply at the appropriate time if it leads to unwarranted inflation.
If a parallel example is used to explain this skill, it goes as follows: There is a diabetic who is clumsy and lazy because he does not get sufficient energy due to cut in sugar intake. Then, there is a smart physician who increases his sugar intake sufficiently so that he becomes active again. Now, if that sugar level in his blood increases to dangerous levels, the physician is said to be able to cut the sugar without harming the diabetic. The ability to change the sugar level in the diabetic just at the appropriate time from more sugar to less sugar to attain the particular goal is called ‘policy maneuverability’.
This micro management is easy for a single diabetic. But if all are diabetic, it may not easy as it is claimed.
IMF: Don’t ease monetary policy
Two days before the Central Bank went for this historic policy maneuverability experiment, the Executive Board of the International Monetary Fund or IMF issued a warning to Sri Lanka in its routine country assessment report. While emphasising on the need for having a holistic approach to solving the country’s alarming economic problems, IMF cautioned against the easing of monetary policy in the next few months and advised that the exchange rate should not be defended aggressively. What it meant was that the Central Bank should not cut its interest rates and promote credit in the hope of stimulating the economy (or giving sugar to the diabetic) and sell foreign exchange from its reserves in the market to prevent a natural fall in the exchange rate. Its policy advice covered a broad range of activities. It said that Sri Lanka should watch inflation closely to prevent it from rising again, reduce unwarranted growth in bank credit, improve the budget by increasing tax revenues and avoid guaranteeing the foreign exchange borrowings which the Sri Lankan banks have been raising recently with the blessings of the Central Bank. Coupled with these good overall economic management policies, IMF has said that the country should have a proper policy package to promote foreign direct investments or FDIs.
Two opinions by two doctors
It appears that the two doctors, the doctors at IMF and the doctors at the Central Bank, have two different treatment packages for Sri Lanka’s ailing economy. Usually, a patient is unable to say which treatment method is suitable for him and he leaves that judgment to the wisdom of the physician treating him. All what a patient wants is that the particular treatment should be effective and he should be cured as fast as possible. A patient has another problem called ‘myopia’, inability to perceive the big picture and how a selected treatment method would affect his overall health not only today, but also in the years to come. This particular weakness in people was called ‘bounded rationality’ by Nobel Prize winning economist Herbert Simon. In bounded rationality, people do not have money or time to look at the big picture; even if they have money and time, they cannot see the big picture because they do not have mental capacity to see it. So, they depend on others who make judgments for them. And those others have the incentive to keep the patient captive to him by giving him sweet drugs and hiding the true nature of the ailment from him. In these circumstances, a patient might favour a physician who will give him many short term palliatives even though those short term palliatives might one day make him really sick endangering his life. Recently, the famous Parker Cartoon illustrated this beautifully: The king announces from the balcony of the palace to people assembled in the yard that he should raise taxes or set up a casino for them to gamble. The people shout back at the king in chorus “Open the casino, Open the casino” demanding the pleasant proposal and ignoring the bitter one which will put the king’s kingdom in the proper shape in the long run.
The Central Bank doctors: Things are not that bad
In the press statement announcing the interest rate cut, the Central Bank has assured the patient that he need not worry because all the tested parts of the body of the patient have been functioning well. The following are some of them.
The Central Bank: The world economy will benefit Sri Lanka
The global economy has been recovering and accordingly USA, Euro area, China and India will return to growth in 2014 if not immediately in 2013. Hence, the Bank implies that Sri Lanka will not have problems about selling its exports to developed countries and getting their people to visit Sri Lanka as tourists. But contrary to the Bank’s expectations, the recovery in India and China would mean the opposite because Sri Lanka imports more from those two countries than it exports to them thereby running significant trade deficits. Hence, economic recovery in these two countries means not that they would buy more from Sri Lanka but that they would sell more to Sri Lanka. The implication is that Sri Lanka will have to earn still bigger trade surpluses with USA and Euro area in order to finance the higher trade deficits that arise as a result of the higher growth in India and China. More imports from India and China will give more sugar to Sri Lankans to enjoy their life; attaining bigger trade surpluses with USA and Euro area means that they have to work harder to earn those sugars.
The Central Bank: Stimulate the economy to compensate for the decline in exports
On the domestic front, Sri Lanka’s economic growth, according to the Central Bank, will not be that impressive in the first quarter of 2013 because of the slow growth in exports. But, this is not an experience which Sri Lanka had only in this year but a continuation from the last year. In 2012, exports fell by 7.4 per cent and in the first quarter 2013, they have declined by 8 per cent. With a gloomy economic forecast in the two major export destinations of Sri Lanka, namely, USA and Euro area, the recovery of Sri Lanka’s exports to the glorious record level of 2011 cannot be anticipated in the near future. But the Bank has taken solace at the slightly better performance in tourism, IT exports and personal services in the form of health and educational services sold to foreigners in the recent past claiming that the loss in export revenues will be moderated by an increase in the earnings from these services. Thus, the Central Bank has reasoned that the risk to the economy due to slow growth in exports has to be eliminated by increasing the domestic demand and to increase it, it is necessary to promote domestic consumption by lowering interest rates and through that measure, increasing credit levels.
The Central Bank: Low single digit inflation will improve policy maneuverability
The policy maneuverability skill which the Central Bank has claimed it has acquired arises from its taming of inflation to a single digit level or below 10 per cent in the recent past. That single digit level had been hovering close to the upper bound of 10 per cent per annum for many months in the past, but in April, it has come down to a level of 6.5 per cent per annum. The Bank admits that this might increase in the future due to the recent increases in the electricity prices but when one takes into account of other price revisions such as petroleum prices and bus fares which are also necessary to be effected, the increase in the cost of living index may be a continuous development narrowing the Bank’s policy maneuverability skills. The Bank has implied that even if it goes up to a higher level, there is no need to worry as long as it is single digit or below 10 per cent. Thus, the Bank has expressed its confidence in its ability to intervene and cut inflation if the measures it has taken to stimulate the economy in the form of cheaper and more credit will put pressure for prices to rise again. The Bank has specifically said that there had been a sharp decline in the money supply growth in Sri Lanka in 2012 auguring well for future inflation, but that ‘sharp decline’ has simply been from 19 per cent in 2011 to 18 per cent in 2012. The Bank’s only consolation is the expected decline in credit to public sector in the remaining part of the year moderating the money supply growth to the targeted growth of 15 per cent by end-2013. But that public sector credit decline depends on factors beyond the Bank’s control and with continuing heavy losses in major public corporations and the declining tax revenues of the government as a percentage of GDP, the attainment of that goal appears to be far away from the reach of the country.
The Central Bank: Being happy for the wrong reason
On the external side, the Central Bank has expressed its satisfaction about the decline in imports, the decline in the trade deficit, increases in services income and remittances and finally the generation of a surplus in the balance of payments. The net result of all these has been the appreciation of the Sri Lanka rupee against most of the international currencies in the recent past and most notably against the US dollar by about 1 per cent by early May 2013. The Bank has downplayed the adverse impact of the decline in exports in 2012 and so far in 2013 just by saying that “In cumulative terms, earnings from exports during the first quarter of 2013 declined by 8.1 per cent, year-on-year”. Given the risk of falling export earnings on the economy, it appears that the Bank has been happy for the wrong reason.
Two doctors seeing the same symptoms from two different perspectives
Thus, it appears that the main dispute between the Central Bank and IMF has been due to the difference in reading the main economic numbers by the two institutions. While the Central Bank has read them as moderately risky and could be corrected by reducing interest rates, IMF has viewed them as high risk needing a comprehensive economic reform programme to be implemented by the government with a facilitating monetary and exchange rate policy regime by the Central Bank. The Central Bank’s prescription with cheap credit will give more money into the hands of those who wish to borrow from the banking system. Thus, its prescription is sweet medicine and will be loved by everyone. But a comprehensive economic reform programme aiming at putting the economy in a sustainable growth path in the long run is bitter medicine forcing everyone to take a cost today but for the health of the economy tomorrow. Naturally, the prescription by IMF may not be viewed as palatable by many who have been used to taking sweets in excessive amounts.
A comprehensive reform programme a must
But without a comprehensive economic reform programme, can the Central Bank attain its goal of stimulating the economy? Unlikely because there are several points through which its low interest rate policy will leak out of the economy.
Cheap money will promote growth in other countries
When the Bank reduces its interest rates, money will become cheaper and commercial banks will find that they do not have to offer high interest rates to mobilise deposits. So, the first adjustment in the economy will be a downward movement in the deposit rates. The savers are now forced to make a choice, whether to increase consumption because saving does not bring them an adequate interest income to postpone the current consumption or move their funds to places which have shady track records as trustworthy financial institutions but offer high interest rates. If they choose in favour of consumption, the Bank will feel that its objective of increasing the demand in the economy has been realised. This is simple Keynesian economics – due to the leading British economist of the 20th century, John Maynard Keynes – which advocates the increase in demand in order to promote supply. But, as warned by the founding Governor of the Central Bank, John Exter, as far back as 1950, in a free trading economy, that is an invitation to import more and with increased imports, an invitation to perennial balance of payments crises. Thus, low interest rates will promote economic growth in other countries instead of promoting growth in Sri Lanka.
Low interest rates promote shady financial institutions
On the other hand, if savers choose in favour of shady financial institutions for shifting their deposits, the likely outcome will be the development of high risk financial deals like pyramid schemes which the Central Bank wants to stop and proliferation of unviable financial institutions. Either one will not augur well for the country’s economic growth on a sustainable basis. The financial history is full with evidence of interest rate cuts leading to such financial scandals and eventually to financial crises.
Give cheap money and the government will not reform itself
Then, who will be the beneficiaries of the low interest rates? The government, as announced by the Bank itself in its press statement, by having a lower credit cost and the loss making state corporations because they can now finance their losses by borrowing cheap money from banks. But with an undisciplined budgetary system in the government and undisciplined financial management in state enterprises, providing cheap money will be like watering a sinking well – with water disappearing faster than the filling of the well. Thus, the interest rate cut by the Central Bank with the noble objective of stimulating the economy will simply take the pressure away from the government and the loss making state enterprises for going for comprehensive reforms on a priority basis.
Cheap money will worsen BOP too
The increase in imports when exports are experiencing declines will worsen the balance of payments situation in the country. Who will be the likely victim? It is the exchange rate which will go under pressure for depreciation. It therefore appears that the Central Bank is simply pursuing a growth objective without considering the impact that objective will bring to the overall macroeconomic stability of the country. The Bank has assured the people that it has skills in ‘policy maneuverability’ if things go wrong meaning that it can beat the markets. But the combined wisdom of markets is superior to the combined wisdom of all those in a central bank. This led the founding Governor of the Central Bank, John Exter, to advise that in the event of a dispute between a central bank and the market, one should bet on the side of the market and not on the side of a central bank if one is interested in winning.
The Central Bank is to attain economic and price stability
The Central Bank’s objective is to attain both economic and price stability and not mere price stability. The wisdom of those who amended the Monetary Law Act to give effect to this objective in 2002 was that if it is mere price stability, the Central Bank will fall into the wrong track of stabilising a price index instead of stabilising the entire macroeconomy.
The Central Bank’s recent concentration has been on the former while the IMF’s advice has been on the latter.
*W.A Wijewardena can be reached at email@example.com