By Hema Senanayake –
It has been reported that a concerned journalist asked a critical question from the Central Bank governor Dr. Nandalal Weerasinghe during the monetary policy review briefing held on November 24th, 2022, at the Central Bank of Sri Lanka (CBSL) premises.
The question was whether there are actions require other than passing of the budget and debt restructuring in order to qualify IMF extended fund facility. This is an interesting and important question.
Dr. Nandalal replied that enacting the new Central Bank Act to enable the CBSL to operate independently which is one of the requirements set forth by the IMF for granting the Extended Fund Facility (EFF) arrangement. For the first time we are hearing that it is another condition of IMF.
We agree that CBSL should be functioned independently without any political interference as many other independent commissions such as election commission, police commission, bribery commission etc. Such institutional framework is necessary to run a robust democratic governance even though such independent institutions tainted with political nominees and appointments as at present.
But the concept of independent central bank is to make the central bank independent from the government is to ensure that it is dependent on the IMF. I guess IMF does not want to do that intentionally, but that is what happens if the new Central Bank Act is enacted as it is.
No central bank can function efficiently without the formal and due backing of a common taxation authority, which is the government or the treasury department. The only largest central bank that operates without the backing of a formal taxation authority is the European Central Bank and hence it is the weakest among developed economies and had to depend on IMF (or collaborate with IMF) when the crisis of its member state Greece emerged.
As far as I know the new Act of the Central Bank has a very specific amendment to the existing Monetary Act. With the new Act, the Central Bank has been prevented from purchasing treasury bonds directly from the treasury. In the existing Monetary Act, there is no such restriction. With the proposed amendment the Central Bank is supposed to execute its monetary policy through Open Market Operations. This means that the central bank purchases treasury bonds from the market if the Central Bank wants to increase money supply and liquidity of the system or the CBSL can sells bonds if the Central Bank wants to shrink money supply. In short, this means that the central bank policy of buying and selling treasury securities from the open market is the main mechanism of managing the money supply and rate of interest.
In fact, regulating money supply through Open Market Operations in normal periods of economic activity with minor fluctuations of “business cycle” works well. But under the current money system where money supply is elastic, the Central Bank has no enough policy tools to regulate money supply in preventing economic crises or resolving crises. Even in developed economies like the United States, in certain times, the Federal Reserve had to work with the Department of Treasury in resolving economic crises. For example, in collaboration with the Treasury, the Federal Reserve heavily expanded its balance sheet in trying to resolve the extreme credit crunch occurred in the economy in the middle of the Great Financial crisis of 2008. Then after the crisis, there were signs, or some economists anticipated severe credit growth due to an unprecedented expansion of the balance sheet of the Federal Reserve during the economic crisis which possibly could not be contained by mere Open Market Operations. Therefore, the Department of Treasury enacted a legislative bill in 2010 stipulating banks to limit their credit supply. For example, banks should not issue credit more than 80% of the value of a house when a buyer purchase a house and 20% must be equity. Such administrative tools are important in containing credit growth than containing credit growth by increasing interest rate by the Central Bank because conceptually there is a rate of interest that a Central Bank should follow. It is known as the neutral rate of interest, which is the rate of interest that neither increases nor lower the cost of products. This means that a Central Bank should not increase the rate of interest that would destroy the “business confidence” as is happening in Sri Lanka now. Similarly, when there is no advanced entrepreneurial sector or class, what could possibly happen is that Primary Dealers would set the higher rate of interest than Central Bank setting the interest rate. This was happened when Arjuna Mahendran was the governor of the Central Bank. The rate of interest went up suddenly. This might be repeated in the future if the Central Bank prevented from buying treasury bonds directly from the treasury. This is crucial if the Central Bank wants to bring down the currently high rate of interest to a level, a little more than the said natural (neutral) rate of interest.
However, from the Central Bank’s perspective, it might need to acquire a new policy tool to regulate money supply efficiently as current policy tools namely, Mandatory Reserve Ratio and the Rate of Interest are not sufficient to do the job. This policy tool you may find in India. I think, Maynard Keynes might have had a hand in bringing this policy tool to the Indian central banking. However, it is called “Statutory Liquidity Ratio.” This is a policy tool to regulate liquidity in the banking system. This tool works faster in regulating money supply than the Mandatory Reserve Ratio. I think, this is the amendment that should be brought into the Monetary Law Act.
All these means what the country needs right now is not only an independent Central Bank, but an independent Treasury run by serious macroeconomists who work in collaboration with the Central Bank which is governed by a Monetary Board consist of true central bankers and macroeconomists. Our Monetary Board is like the parliamentarians who supports all constitutional amendments. Most of them voted for 18th amendment, 19th amendment, 20th amendment and voted for 21st amendment too. Likewise, our Monetary Board approved Arjuna Mahendran’s approach, Prof Lakshman’s stance, the Cabraal’s fantasy and now Nandalal’s approach. In turn, Dr. Nandalal has said that he has full confidence in Monetary Board. Funny, right?
According to Dr. Nandalal, the Central Bank has already reviewed the new Central Bank Act and the next step is that it should be approved by the Cabinet. I do not think that the cabinet has the necessary technical expertise to evaluate the new Central Bank Act. When President Ranil Wickremasinghe threatens that it needed to be approved quickly to get the Extended Fund Facility from IMF, the cabinet will approve it even without reading it.
But as citizens we need to read it. Not only that it should be subjected to an extensive public discourse. The beginning is that citizens need to know the comments and observations made by the individual member of the Monetary Board in regard to the new Central Bank Act.