Colombo Telegraph

Monetary System Reforms: Sri Lanka Is To Follow The West

By Hema Senanayake – 

Hema Senanayake

Central Bank of Sri Lanka (CBSL) has now made a few announcements in this New Year. Central Bank Governor Cabraal, during the Central Bank’s annual policy speech, said, “Smaller private banks with less than 100 billion rupees in assets should grow or merge during a reasonable period.”

You cannot make banks to grow artificially; they have to grow with the businesses in real economy or in “fictitious businesses” in the financial sector. In view of this what Cabraal was telling is that small banks and non-banking financial institutions must be merged or be sold out to big ones. In regard to mergers, the proposals must be submitted to CBSL by June 2014. This is the first announcement. The second announcement is an intension. It says that CBSL would consider foreign acquisitions of existing banking institutions.

In view of above two announcements, within a few years there will be no relatively small banks or non-banking financial institutions and also there will be expanded foreign presence in banking sector. Are these changes good for the country? This might be the question that we all need to find an answer.

Efficiency of any contemporary economy depends on the efficient functioning of the country’s monetary system. Hence the failure of monetary or financial system will bring down any economy no matter whether it is big or small. This was proved clearly during the Great Recession of 2008. Therefore, ensuring the efficient functioning of the country’s monetary system must be a priority in governance. This is highly important for any country because the modern monetary system is inherently fragile; due to this very reason the professional ethics of CBSL must be at its best.

Modern money, whether it is paper currency or electronic currency, is a fiat currency. Fiat currency is simply defined as any money declared by a government to be legal tender. However, most of the fiat money is produced by the banking system and not by the Central Bank or the government. This is facilitated by a core banking system known as Fractional Reserve Banking system. Though we use the fractional reserve banking system, it enhances the fragility of the monetary system.

Now, you may possibly think that the objective of the proposed changes to the monetary system by CBSL is to increase the stability of a useful but fragile monetary system. Anybody may think that this could be the objective, since Cabraal insists that “Larger financial firms with better capital buffers will be better able to withstand economic shocks.” This is an unproven mythical belief because we saw that the largest bank in assets in the U.S. had to be bailed out in 2008. Similarly, the largest bank in deposits in the U.S. was also bailed out by the government. Therefore, if this is not a reason why the CBSL proposes new structural changes in the banking sector?

My view is that Sri Lanka is under the temptation to build a “New Economy.” In an Industrial or service economy, what is known as real economy is the center of economy. In this regard money was considered as a means to an end. Growth in real economy supports the growth of stock market and financial market and as result it derives an income that contributes to support the consumption. Financial engineering changed this structure or the process which led to the emergence of “New Economy.” In the “New Economy” high-paying service sector jobs are located in the financial sector. Most of the corporate profits are from this sector. In short, as was explained by Prof. Joseph Stieglitz, in the New Economy, something (i.e. money) that was a means to an end becomes the center of economy. I think Sri Lanka intends to move on this path. Proposed structural changes to create big banks through directive merges and the expansion of foreign presence in the financial sector are the necessary first steps towards the “New Economy.”

The next essential step is the creation of “derivative market” in financial sector. When this is done the expansion of financial sector will be limitless. Market capitalization in the stock market will have no limits. Perhaps readers might doubt that how on earth this can be possible. Recently I watched a documentary called “Inside Job.” It was about the financial crisis of the U.S. and Europe. In that documentary an Indian-American Venture capitalist explained as to how the derivative financial products work. In the traditional system, you take a loan from a lender (bank) to buy a house and you mortgage the house to your lender. Then you pay monthly installments to the lender until the loan is fully paid. In this system your neighbor cannot mortgage your house to another lender. But under the “derivative financial products system” your house could be mortgaged to unlimited number of lenders. The only condition is that derivative businesses must be lucrative to the speculators.

When the legal frame work is designed to allow the operations of “derivative financial products” that would facilitate the booming credit insurance business which is also an element in the “New Economy.” In the New Economy the financial sectors should boom. As was said earlier high-paying jobs will be found in this sector, significant percentage of corporate profits also would generate from this sector and even most of the business taxes would come this sector. Finally the New Economy is set: most of the household income will flow from the financial activities and not from the activities of real economy. Something (i.e. money) that was a means to an end becomes the center of a New Economy. So, what is the problem?

The only problem is the risk. The New Economy has its own inherited risks of periodic collapses. The risks are arising from the fact that the New Economy will be greatly built on debt of which a greater part cannot be paid back. Yet, the New Economy is highly attractive to leading economies and hence it will play its historical role before its eventual demise. In theory, in the New Economy, there is a colossal waste of physical resources tied up in the financial sector which could have been otherwise used directly and efficiently to produce goods and services for the true wellbeing of human beings.

But all advanced economies are individually moving towards the New Economy. Basel III convention of capital adequacy is no match to reduce the ever increasing risk in ever growing financial sectors.   After the Great-Financial-Crash, even though they learnt the risks associated with it, individually no country would contain the growth of financial sector without a global convention. Therefore, Sri Lanka cannot do anything by itself. The option available for Sri Lanka is to be on the game as early as possible like Iceland before the crash but cautiously. Therefore, I do not denounce the suggestive structural changes except directive mergers. But what I insist is that CBSL must be fully aware of the rules of the game. But what I see from Cabraal’s above mentioned quote is that CBSL is in a hypothetical illusion.

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