By Hema Senanayake –
Calendar year 2016 begins today. In this year the government is going to learn an economic lesson which had never been learnt in their first full year in office. They will learn that ultimately both monetary and fiscal policy narrowed down to the management of exchange rate. In 2015 the government did fail to understand it and as a result the rupee depreciated to an unexpected level. According to the Minister of Finance himself, the expected value of the rupee against U.S. dollar was close to 130. However, on the last banking-day of the last year the exchange value of rupee was around Rs.145 per dollar.
For any country which uses some other country’s currency such as dollar, as its international reserve currency and also for any country which has been posting a current account deficit for a significant number of years like Sri Lanka, the both monetary and fiscal policy ultimately narrowed down to the management of exchange rate, if that country did not have enough non-credit based inflow of dollars (foreign exchange) which are not posted in the nation’s “current account.” This is not difficult to understand. For example, if the rupee depreciated from its current value of Rs.145 to Rs.160 or 165 per U.S. dollar in this year, it will bring negative chain effect across all sectors of the economy with little positive effect on exports.
However, some economists who are critical about the depreciation of rupee do blame the Central Bank of Sri Lanka (CBSL) for adopting “floating exchange rate arrangement.” It is true that Sri Lanka has been previously classified as having stabilized or fixed exchange rate arrangement. Usually International Monetary Fund (IMF) publishes a report each year classifying all its member countries (188) in terms of exchange rate arrangements adopted by each country. Accordingly, in 2014 report IMF has classified Sri Lanka as a country which moved to a stabilized arrangement from floating, (refer page 3 of IMF report). When the 2015 report is published by IMF, it will reclassify Sri Lanka as having moved back to floating regime from stabilized arrangement. Can any country like Sri Lanka which continue to meet its Balance of Payment requirements through borrowed money from foreign sources, choose as to what kind of exchange rate arrangement be adopted? My obvious answer is “NO.” It has to adopt “floating regime” under the given circumstances.
Yet, this doesn’t mean that Sri Lankan rupee should continue depreciating. If Sri Lanka is going to have that fate in this year, for that matter the blame should go primarily to CBSL for bad monetary and monetary policy management and to the government as a whole. Why?
Let me explain it by citing a few examples here. It is true that certain consumer imports might have negatively contributed to the current account and as a result to the Balance of Payment of the country. It also can be true that import of cars for personal use might be the significant issue. I think this situation has previously been observed by the Central Bank too.
I guess that could have been the reason to reduce the loan-to-value ratio to 70% by CBSL a couple of months ago. Prior to that, financial institutions had been providing loans amounting to the full value of the vehicle for prospective buyers. After the loan-to-value ratio is reduced, the prospective buyer has to pay 30% of the value upfront when buying a vehicle. This rule could have resulted in reducing car sales resulting lessor number of car imports. The monetary effect is that the issuance of loans would be reduced if vendors did not try to sneak through the administration of the policy by CBSL. Except for a few auto traders, prospective car buyers did not protest for this policy.
However, the Minister of Finance increased the loan to value ratio to 90%. That happened before the budget.
From the budget, the same Minister of Finance lamented saying that 60,000 new cars per month is registered and that is too much for the road net-work. Then he proposed to stop issuing all tax free car permits and further increased taxes on small and medium size electric cars. The objective again was to reduce car imports but not by reducing the issuance of loans but with an administrative rule. But this time around people protested. This is the difference; when the monetary policy tools are used to contain imports people will not resist that much but they will not tolerate when their previously enjoyed privileges are removed by ad-hoc administrative rules.
However, this endeavor has failed now. Prime Minister assured that the car permits will be issued again. President issued a directive saying not to increase the tax on eco-friendly cars. These reversals of budget proposals are not simple measures.
Therefore, the only option available now is to use monetary policy tools to contain imports through the reduction of the issuance of loans because without loans consumer imports cannot rise that much. However the reduction of loan-to-value ratio is not a proper monetary policy tool.
The customary policy tool on the supply-side of money is known as Statutory Reserve Ratio (SRR). By increasing or decreasing this ratio the CBSL can regulate money supply. When the ratio is increased the money supply (i.e. loan issuance) is reduced and when the ratio is decreased relatively money supply is increased. The CBSL used that policy tool a few days ago exactly on 30th December. On that day the Monetary Board decided to raise the SRR by 1.50 percentage points to 7.50 per cent from current 6.0%, effective from 16 January, 2016. Is this good? Yes it is but not much. Why? Let me answer as follows.
People save money in commercial banks. In turn commercial banks issue loans to customers. How much loans can banks issue? You might think that the loanable funds may be equal to savings in the bank. This is true, only in regard to certain saving banks which do not operate “current accounts” for customers. But for designated commercial banks loanable funds are exponentially higher than that of deposits of the bank. The reason is that commercial banks can virtually create monetary substitute known as “credit money.” It is this money that they lend.
Now, I am asking you if the commercial banks are not allowed to create money, will the issuance of loans be reduced. Yes, it is. In such an event, will it be useful to reduce imports. Yes, it is. If this is true, the CBSL must invent a new policy tool which can effectively and quickly regulate the creation of “credit money” in the system because the monetary policy tool call SRR can only reduce a fraction of money which could potentially be created by banks. Also, SRR does not work in short term. This is the reason that I believe that CBSL’s recent action to increase SRR would have very minimal positive effect on an impending Balance of Payment crisis. Sans good policies foreign borrowing is the next and worst option available for the government.