13 December, 2017

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Why Engaging In Commercial Businesses Is Taboo For Central Banks

By W.A Wijewardena –

Dr. W.A. Wijewardena

Principles of Central Banking 5

John Exter to the Central Bank: Don’t engage in commercial businesses

The father of the Sri Lanka’s Central Bank, John Exter, was emphatic on one point when he drafted the Monetary Law Act or MLA, the legislation under which the Central Bank has been established. Going by the traditional central banking principles, in the General Section of the Exter Report, he prohibited the Central Bank to engage in commercial businesses. This prohibition has got into the MLA as Section 117 of the Act in the form of three separate sub sections exactly as recommended by Exter.

The Central Bank is not to engage in trade or commercial businesses
The first sub-section says that the Central Bank shall not engage in ‘trade or have any direct interest in any commercial, industrial or other undertaking’. What this means is that the Central Bank cannot run, if a very simple example is considered, a dairy farm or own shares of a dairy farm owned by someone else. However, as a practical measure, the Central Bank has been permitted to own a business enterprise if it has to acquire it in the process of recovering any loan it has granted to, say, a commercial bank. But John Exter has advised the Central Bank and it has been provided for in MLA that the Bank should dispose of that enterprise as soon as possible. In other words, the Central Bank should not continue to own business enterprises.

The Central Bank is not to buy shares of commercial banks

The second sub section has prohibited the Central Bank to buy shares of any bank or any company or lend money against the security of such shares owned by someone else. Buying shares of banks or other private companies is therefore a taboo for the Central Bank whether the Bank does it directly in its own name or indirectly by using the agencies managed by it.

The Central Bank is not to lend against immovable property

The third sub section has prohibited the Central Bank to accept immovable property or title documents relating to such property when it grants loans. For instance, if a commercial bank wants to borrow from the Central Bank, it cannot accept the building owned by that commercial bank as security. This provision has removed any possibility of the Central Bank coming to own buildings and real estate when its loans are not repaid by the respective borrowers. It then follows that the Bank should not buy or construct unnecessary buildings or invest in real estate.

Follow the spirit and not the letter of the law

These three prohibitions imposed on the Central Bank should be followed by it in the spirit of the law and not to its letter. What it means is that the Central Bank should not seek to circumvent these prohibitions by owning banks, company shares or business enterprises indirectly through some of its agencies thereby claiming that it is not the Central Bank which owns them but some other agency. In other words, the Bank should not own businesses or banks either directly or indirectly.

These prohibitions are universal

These types of prohibitions have been imposed on central banks in general by the legislations under which they have been set up. MLA in Sri Lanka was enacted in 1949 and one may argue that the world has changed significantly since then making such prohibitions irrelevant or unnecessary in the current context. But that is not the case. For instance, the new Nepal Rastra Bank Act which was enacted in 2012 too has the same three prohibitions imposed on it by Section 7 of the Act in a special section titled “Functions not to be carried out by the Bank”. Similarly the Royal Monetary Authority of Bhutan Act, enacted in 2010, makes the same prohibitions in Section 11 of the Act with the special provision that RMA should not do so either directly or indirectly. Hence, these provisions are universal and have validity for all the time.

There are valid reasons why central banks should not engage in commercial businesses either directly or indirectly.

Central banks create money just by book entries

In the first place, unlike other businesses in an economy, central banks get their money for investment in commercial businesses not by hard work and sacrifice but by just resorting to very easy-to-make double entry book entries. As explained in the Principles of Central Banking Number four published in this series previously (available at http://www.ft.lk/2013/09/23/should-central-banks-make-profits/), central banks just make money by debiting an asset account and crediting a liability account. For instance, if a central bank wants to buy shares of dairy farm, all it has to do is to create an account called share investments in a dairy farm and debit that account by the value of the shares. To complete the double entry, it will credit the bank with which the dairy farm maintains its account. When the commercial bank concerned withdraws money to pay the dairy farm, it will ultimately end up as currency issued by the central bank which in the common parlance is known as ‘money printing’ by the central bank. Thus, a central bank can invest money in a commercial enterprise just by increasing its assets as well as liabilities at the same time.

All others have to make sacrifices to earn money

This is indeed a miraculous activity. A private citizen cannot perform such a miracle. If he wants to buy shares of a dairy farm, first of all he has to save some money out of his income by cutting down his consumption. To earn income, he has to either offer his labour in the market or sell some of the properties he has acquired in the past. Both are sacrifices. Or else, he has to borrow money from someone to buy shares. But it means that he has to make a sacrifice in the future when he has to repay that loan by cutting his consumption at that time. Then, refraining from consumption either today or on a future date is another sacrifice. Hence, it is only through sacrifices that a private citizen can buy shares of a dairy farm.

Central banks don’t make sacrifices

A central bank does not have to make a similar sacrifice either today or on a future date if it creates money to buy shares of a dairy farm. In fact, in the current period, it makes a profit by creating money which is the difference between the face value of the money it creates and the actual cost of creating that money. For instance, if a central bank creates a One Thousand Rupee note, it can buy shares of a dairy farm to that value. But it does not spend Rs 1000 to create that note. Its cost is the cost it pays to the currency printer and the fraction of the cost attributable to that currency note in the running of the bank. Assume that that cost is just Rs 15. In this situation, it makes a profit of Rs 985 by printing a currency note with a face value of Rs 1000. This profit is known in economics as ‘seigniorage’. Hence, from the point of view of a central bank, it is highly profitable to print a currency note with a face value of Rs 1000 just spending Rs 15 and buy shares of a dairy farm. If it prints currency notes of higher denominations, the profits are bigger since the cost of printing a currency note, irrespective of the denomination, is practically same.

People make sacrifices when they accept central bank money

But the moneys issued by a central bank are a borrowing today with a promise to pay back tomorrow. But it is not a direct borrowing as is being done by others in an economy but an indirect borrowing. The borrowing takes the form of promising those who accept that money by sacrificing their real resources (labour, property etc) that they can command a basket of goods and services from the market. Thus, those who accept that money initially from the central bank will exchange it with those who own the goods and services which they desire to have. Likewise, the initial One Thousand Rupee note so created by the central bank changes from hand to hand many times into an indefinite future date until it is completely worn-out. Suppose the last man who comes to own that note wants its value from the central bank. Does the central bank make a real sacrifice to repay the value of that currency note like a private citizen? Under the present paper money system where the money created by a central bank is not backed by a real asset like gold, it will simply take the old currency note and give him a new currency note of the same face value. The printing cost of the currency note may have increased by that time due to the domestic inflation, but in all likelihood, it should be less than the face value unless there is hyperinflation in the economy at that time.

But then who makes a sacrifice? It is succession of people who have used the old currency note and the last man who has now got the new currency note in exchange of the old note because all of them could have bought only a smaller quantity of goods and services than the quantity which the previous person would have bought. This decline in the basket value of the currency note due to inflation is a real sacrifice they make and it is known as paying an inflation tax to the government. Hence, a central bank is able to buy the shares of a dairy farm by creating money today without making a sacrifice either in the current period or in the future.

The miracle of money printing

Then, isn’t it marvellous to print money and own commercial enterprises by a central bank? Some appear to believe so. For instance, President Robert Mugabe of Zimbabwe, as reported by Time magazine in 2005 is reported to have said that if his government did not have money to start projects, he would get the central bank to print that money. But inflation in his country accelerated to one billion percent per annum according to some private sources causing his people to lose everything kept in that money and forcing them to make the biggest sacrifice in their life.

Excess money leads to inflation

But the danger of a central bank creating money and investing in commercial businesses is the possibility of, as argued in this series of articles, producing more money than the money which people want to hold. Such money will find its way to the market creating an artificial demand for goods and services leading to an excess demand. That excess demand will force local prices to increase on the one hand and through increased demand for imports bring in balance of payments difficulties. Hence, it is counter to the main objective of a central bank, namely, the preservation of the stability in the price level. In other words, a central bank will self-defeat its own objective.

Is little bit of inflation necessary for growth?

But then some people argue that a little bit of inflation is necessary for an economy to grow. It is like if a human being is to attain the objectives of his living he has to activate various parts of his body burning energy and producing heat in the process. Thus, heat production in a human body is a necessary requirement. Similarly, an economy which does not move forward on its own, it is argued, that the demand created by the additional money supply will activate the supply agents generating growth and resource utilisation in the economy. Though it generates inflation, it is argued that such inflation is a ‘necessary evil’ that cannot be avoided if an economy is to grow. If that inflation can be kept under control, then, it is desirable to generate economic growth.

Small inflation grows into big inflation

But the problem is the inability of the politicians and the policy makers to identify what that little inflation is. Once they have savoured the taste of free money which does not involve a sacrifice on their part but by all others, they cannot resist the temptation to go for more money under the guise of having more commercial enterprises owned by central banks. Thus, the little bit of inflation becomes big inflation causing everyone to lose their wealth on the one hand and creating severe macroeconomic imbalances and balance of payments problems on the other. This made the first Sri Lankan Governor of the Central Bank, the late N.U. Jayawardena to remark, quoting American economist John Kenneth Galbraith, that “being happy about a little bit of inflation is like a woman claiming that she has no problem because she is only a little bit of pregnant”.

The central bank is not a player but a referee

The second reason why central banks should not undertake commercial businesses or own shares of commercial banks, directly or indirectly, arises from the serious dents it would make on the governance practices of a central bank. A central bank is supposed to be an impartial referee and not an active player in the market. When a central bank owns its own businesses or commercial banks, it becomes difficult for the bank to carry out its monetary policy or financial system stability measures objectively and impartially. For instance if the inflationary conditions in the country require it to raise interest rates and restrict credit growth, it will be unable to take these policies for the benefit of the country without hurting the businesses it owns. In such an event, a central bank will be compelled to favour its own businesses to the detriment of all others in the market. Similarly, when a central bank owns shares of commercial banks, it will not be able to implement effective banking supervisory and regulatory measures on those banks. For instance, if a central bank is to introduce a capital strengthening program, it will not be able to do it objectively because it may have to enforce a relaxed requirement on those banks owned by it. Such regulatory forbearance will make those banks vulnerable to even the slightest adverse external shocks without adequate levels of capital in them.

Bias toward central bank’s own businesses

Such biased treatments by a central bank will damage a market in two ways. First, the central bank will lose the trust and confidence of the market, a must if a central bank is to attain its objectives effectively. Second, it will give wrong incentives to the managers of those businesses because they would not take effective measures to manage risks and operate their businesses efficiently. Economists call this moral hazard behaviour by those managers. Hence, it is in the interest of the central bank itself that it should not undertake commercial businesses, own shares of commercial banks or take ownership of immovable property. Further, when a central bank owns banks, businesses or property etc, the energy and resources which it will have to use for attaining its main objectives will be wasted for managing such properties.

These age-old central banking principles should not be taken lightly by a central bank and if it has got into such businesses, it should divest such businesses as fast as possible.

*W.A. Wijewardena can be reached at waw1949@gmail.com

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Latest comments

  • 1
    0

    This is what I have ben saying for the last three years with respect to CBSL trading in shares of commercial banks using the EPF (agency function)! Thank you Mr Wijewardene for brining this to the notice of the public (once again).

    Harsha

  • 0
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    In an Islamic economic system, money supply is created in co-ordination with GDP and with the proven reserves of the natural resources of a country. The strength or weakness of a Fiat currency is on the purchasing power, that is; determined by the demand and supply of a country’s produce. Remember how the Barter system was formed in the early days before paper money was invented. Today it has evolved to digital bits and bytes.

    In an island with 10 people or a small number of people can effectively trade their goods and services with a mutually agreeable trade off. My fish for 2 coconuts. This worked for a while until we shifted to Gold as a medium of exchange. My point is when the population increases and with that more goods and service are produced in the market place; the Law of supply and demand says as the supply of money of claims increases relative to the supply of tangible assets in the economy. The disparity occurs when the Federal Reserve / Central Banks issues Bonds without being backed by tangible wealth rather by the promise to payout by future tax revenues.

    While Halaal is banished in Sri Lanka, Dubai takes the lead to prosper on others weaknesses.

    http://gulfnews.com/business/general/dubai-islamic-economy-strategy-built-on-7-pillars-1.1239915#.UlI-RBsNs4g.facebook

  • 0
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    When a private individual earns money,it is the result of an effort or activity. A labourer earns Rs 1000 a day as a result of work and creating some value. The money he earns is valued against his knowledge, skill and work.

    The Central Bank can print paper money which has no value. It dilutes the value of money already in circulation. The public who create value pay the price as their past work is devalued. Hence the Central Bank has no business to print or engage in economic activity using printed money other than for special exigences.

    EPF / ETF funds belonging to the working people and are deposited in special funds to ensure that at the end of ones working life there is a reserve to get by. CBSL is the sole guarantor of these funds and they should be invested in long term government bonds at the best rates of interest. The workers deserve no more.

    CBSL has no ethical right to invest these hard earned moneys in speculatory transactions on the CSE to help various political stooges make a fast buck. CBSL has become a political staging ground for ill conceived ventures like the commonwealth games. CBSL has also acted to help the Govt to takeover and appoint directors to the boards of private banks using EPF / ETF funds. These are some of the political activities indulged in by CBSL using public money.

  • 0
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    what about commercial banks perfoming functions of a central bank?

  • 0
    0

    what about commercial banks perfoming central bank functions

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