ECONOMYNEXT - Economists and governance activists have been shocked over recent threats and actions by Sri Lanka’s current administration to undermine the independence of the Central Bank and intimidate its new highly respected governor.
Attempts to undermine the independence of central banks both here and abroad are of course not new. The entire question of ‘central bank independence’ comes because politicians try to misuse central banks.
Finance Minister Ravi Karunanayake has been in the forefront, making statements and budget proposals that seem to undermine the independence of the Central Bank. All this has come as a bigger shock than normal to the public because this administration came to power promising good governance or ‘Yahapalanaya’, riding on the cry of many civil society activists.
The path to politicising a country’s money supply to impoverish the poor was legitimised by Keynesian economic policy, which became widely accepted after World War II. A foundation was also laid by the Federal Reserve after the First World War by loosening policy.
But the Fed’s machinations soon led to the Great Depression, and in 1933, the US dollar was devalued for the first time. The earliest case to manipulate the money supply was articulated by John Law, a Scottish economist. Rejected at home, he went to create a central bank-like institution in France, which led to an economic collapse. It was ‘born again’ in a much more respectable guise under John Maynard Keynes.
Sri Lanka has had repeated economic and currency collapses, but the Central Bank has not been substantially reformed to increase its ability to provide sound money (restraining its ability to create instability). Indeed, the opposite may even be true.
Finance Minister Karunanayake’s most recent comments are targeted at the un-named Central Bank officials who allegedly want to depreciate the currency. Incidentally, in some countries, including the US, the exchange rate is considered a legitimate perview of the Treasury.
The supreme irony behind the current accusations, however, is that Sri Lanka’s currency is depreciating because the Central Bank is printing money, at the behest of the Treasury, more often than not.
The massive bout of money printed to repay a maturing bond on January 02 is a good example. This also raises the question whether someone is giving bad advice to the finance minister to force the Central Bank to print money, undermine its monetary stance and generate instability.
Central Bank Independence
This is where Central Bank independence comes in.
Central bank independence is generally understood to be the freedom of central bank officials to conduct monetary policy (control interest rates by printing money) independent of elected politicians (finance minister) and bureaucrats outside the agency.
But this naïve proposition pre-supposes that central bankers themselves want a strong currency and low inflation. This is not always the case when bureaucrats in a central bank are misled by Keynesian neo-Mercantilism.
The opposite is also true. If politicians believe in sound money, a central bank will bat on behalf of the poor with a strong or hard currency and the low inflation that comes in its wake.
Singapore’s monetary authority has as its chairman the country’s finance minister. Finance Minister Goh Keng Swee, who had studied at the London School of Economics (where Friedrich Hayek taught and debunked Keynes before the World War), had natural misgivings about the false promises of Keynesian stimulus and its natural results of currency collapse and inflation.
"None of us believed that Keynesian economic policies could serve as Singapore’s guide to economic well-being," Goh said once.
"Our economy was and is both small and open. Financing budget deficits through Central Bank credit creation appeared to us as an invitation to disaster. There was no effective way of exchange control in an open trading economy like ours to deal with inevitable balance of payments troubles.
"It's also not surprising that when the Monetary Authority of Singapore (MAS) was set up, the chairman was, by law, the finance minister.
"World Bank experts advised us against this, since the chairman should be an independent person with sufficient authority to resist a finance minister’s request for money to finance a budget deficit."
However, given the view of Singapore’s politicians who believed in hard work and not central bank credit (money printing), central bank independence (independence from the Treasury) was not necessary, he said.
Singapore solved the problem by keeping its colonial era currency board and having a requirement for foreign reserves to exceed domestic reserve money (the monetary base) at all times, thereby making the Singapore dollar a hard currency fixed to the US dollar.
Later, the MAS was reformed to allow it to change the exchange rate at will. To target the exchange rate effectively, Singapore does not have a policy rate. The requirement to back the money supply with forex reserves remained.
China began accumulating large foreign reserves and having low inflation after Zhu Rongji, the then Vice Premier, was made central bank governor, though reforms started in the late 1980s beginning with barring People’s Bank of China financing of state enterprises with printed money.
In 1998, Gordon Brown, then Chancellor of the Exchequer (Finance Minister), was a key figure in starting inflation targeting and giving interest rate independence to the Bank of England and defending the policy steadily against critics. He had a doctorate in history.
All this goes to show that if politicians do not believe in inflation and currency depreciation (or if they went to the 'right' school, like LSE or the University of Chicago), a central bank can easily keep the economy stable and inflation low, with or without formal central bank independence. If the politicians went to the wrong school (i.e had the wrong ideology or went to Cambridge, for example), central bank independence is required.
If the central bankers themselves went to the wrong school of course, central bank independence will also not help.
It was no accident that Governor A S Jayewardene, who made the first attempts to reform the Central Bank, market base bond auctions and start to reduce inflation, studied at LSE.
When Sri Lanka’s Central Bank was originally set up, around 1950, with technical support from John Exter, a Federal Reserve official, it was not intended to be a tool for unsound money leading to frequent currency collapses and high inflation.
The intentions were broadly to be able to ride out booms and busts coming through a currency board (essentially from the anchor currency central bank) and allow domestic banks to grow faster with a lender of last resort (reverse repo) window and better bank regulation.
Preserving the external value of the currency was a specific objective at the time. However, this is incompatible with having low interest rates to ‘stimulate’ an economy. If rates are targeted, the currency will move. Subsequently, this objective was removed.
The end result was that not only did Sri Lanka experience commodity bubbles and economic downturns when the Federal Reserve generated bubbles, but Sri Lanka also had multiple internally generated balance of payments crises and economic collapses in between from its own money printing.
The Federal Reserve-fired bubble collapse in 2008/9 created a BOP crisis here. But in 2012, another crisis was created as money was printed to finance energy subsidies coming from a drought, and in 2015, yet another crisis was triggered by financing salary increments in a budget that went off the rails.
Remarkably, all this was prophesied in an analysis published in UK-based The Banker magazine in July 1950. This is the same magazine that named Minister Karunanayake as Finance Minister of the Year. Sri Lanka abolished the currency board that kept the currency stable since 1885 and the economy a generator of jobs that required migration.
After World War II, the US was looking to break the so-called ‘Sterling area’ (mostly currency boards with no money printing and fixed exchange rates), which had free trade. Britain was experiencing balance of payments troubles due to wartime money printing and there were exchange controls with the 'dollar area'.
The US Treasury and State Department pushed many countries to adopt dollar pegs, holding as the advantage ‘independent monetary policy’. John Exter, a Fed official who helped create the Philippines central bank (which went bankrupt due to money printing and forex swaps), also built Sri Lanka’s Central Bank.
The Banker noted that Ceylon Monetary Law Act has been drawn up on American "tutelage and along the lines that have been the subject of experiment in certain Latin American countries for some eight years past".
The central banks of Latin America turned out to be an unmitigated disaster and their currency crises deficit spending, high inflation from Argentina to Mexico are now the stuff of economic legend.
“The step from an ‘ automatic’ currency system (such as that which Ceylon inherited with its old Colonial Currency Board) to an ultra-modem ‘managed’ currency system is necessarily fraught with great dangers and there may be some who will regret that Ceylon has decided to run such risks at this time,” The Banker said prophetically in 1950.
According to The Banker, Exter did not intend for the central bank to engage in any exchange controls. But by 1952, new exchange controls were brought as the inevitable balance of payments troubles started as money printing began.
The Banker says Exter tried to save the central bank from "becoming the milch cow of an improvident government (as so many central banks in developing economies have become in the past)" by limiting financing of the government through ‘provisional advances’ that had to be repaid in six months.
In practice, these moneys were never paid back and became a permanent driver of credit and inflation, probably illegally. But there were loopholes.
"This is a novel and interesting limitation, although it is not even a technically watertight safeguard against government misuse of the central bank," The Banker opined correctly.
"So long as open market purchases of government securities are allowed (as, of course, they must be), it is very difficult to prevent these becoming an indirect means of making central bank credit available to finance government deficits.
"The experience of the next few years will be watched with interest to see whether the Ceylon experiment will indeed show the rest of the Empire the way a developing economy should take to free itself from the as-yet-ungauged disadvantages of the currency board system or whether it will merely provide another example of the tangled skein so often woven by those who set out with the good intention of making finance “the servant instead of the master of the people."
We know now. The experiment failed. Printed money became the master and people became slaves.
Sri Lanka spiralled from exchange controls to trade controls and became one of the most backward nations in Asia. In the 1970s, after the Bretton Woods system collapsed, people in Sri Lanka starved with the most draconian exchange, price and trade controls imaginable, with almost all the issued Treasury bills being with the Central Bank.
Meanwhile, countries with currency boards such as Singapore and Hong Kong leapt ahead.
One of the biggest ironies is that a lender of last resort window that came with Ceylon Central Bank was expected to help expand the banking system in the island. But Singapore and Hong Kong became international financial centres with very limited LOLR facilities.
If the Central Bank is not reformed, grand plans to make Colombo a financial centre will come to nought.
Hard Budget Constraint
A currency board is a hard budget constraint. Without a central bank, interest rates rise swiftly and economic growth falls when governments try to deficit spend. If breaks are not put sovereign default is the result. With a central bank busily printing money, the economy will grow with deficit spending (however temporarily) for two or even three years before the collapsing in high inflation and balance of payment troubles. By depreciating the currency, debt can be inflated away and sovereign default avoided.
This has been happening in never-ending cycles since the creation of the central bank in Sri Lanka.
It is difficult to restrain politicians without re-creating a currency board. But some ‘fast and dirty’ changes to the Monetary Law Act can be made to restrain the Central Bank and reduce the ability for it to be mis-used. Section 112 of the Monetary law says:
"The issue of securities of the Government or of any of the agencies or institutions referred to in subsection (1) of section 106 shall be made through the Central Bank, which shall act as agent, and for the account, of the Government or of such agency or institution.
"Provided, however, that except in the case of treasury bills, for which the Central Bank may make direct tenders, the bank shall not subscribe to any issue of such securities or agree to purchase the unsubscribed portion of any such issue."
This section should be overhauled to say that the Central Bank may not make direct tenders to any Treasury auctions. However, for the time being, the Central Bank may be allowed to buy Treasury bills for US dollars, specifically to repay any dollar debt of the government.
According to Section 116, the Central Bank has to give the finance minister a confidential report on the current monetary situation and effects, if any, of fiscal policy to achieve the objectives of the Central Bank, which are now ‘economic and price stability’ and ‘financial system stability’, before each budget.
“In the event of any difference of opinion between the Minister in charge of the subject of Finance and the Monetary Board as to whether the monetary policy of the board is directed to the greatest advantage of the people of Sri Lanka, the Minister in charge of the subject of Finance and the board shall endeavour to reach on agreement.
"If the Minister in charge of the subject of Finance and the board are unable to reach agreement, the Minister in charge of the subject of Finance may inform the board that the Government accepts responsibility for the adoption by the board of a policy in accordance with the opinion of the Government and direct that such a policy be adopted by the board.
"Where a direction is so given by the Minister in charge of the subject of Finance, the board shall carry out that direction.”
This passage has to be repealed in toto. It will give much-needed independence to the Central Bank. The monetary report, however, is a good idea, but it must be made public. Confidential reports are no good. The minutes of monetary policy meetings should also be made public as soon as possible. In fact, the much ballyhooed claims that the Central Bank will move to a ‘flexible inflation targeting regime’ is a pipe dream if central bank independence is not achieved.
The events in late December 2016 and January 02, 2017, where the Central Bank was forced to print tens of billions of rupees to repay a maturing tranche of bonds, generating over Rs100 billion in excess rupee reserves in the banking system, is a case in point.
An epic battle was fought with the President and the US Treasury in 1951 by the Fed to get its independence. Because the Exter report came three years before the battle, Sri Lanka did not benefit from the experience.
From the point of view of sound money, the current Central Bank Governor Indrajit Coomaraswamy unfortunately went to the worst school possible to get his bachelors and masters’, according to publicly available data. Despite going to Cambridge, however, he is not a believer in deficit-fired bubbles.
Coomaraswamy has first-hand knowledge of Sri Lanka’s economic troubles, and the integrity and stature to rebuild public confidence in the bank. Razeen Sally, an internationally renowned economist, has gone public saying he is the only good appointment made by this administration.
In the aftermath of the so-called bond scams, it has been shown that there are still straight dealing officers inside the bank who will act if the correct leadership is given. There are also other moves that can be made to improve the independence of the Central Bank without making legal changes.
The governor should avoid going to economic policy meetings at the Treasury where he is exposed to being outnumbered in a meeting. Let a junior officer go. If anyone in the finance ministry wants to meet the governor, let them come to the Central Bank.
This column is based on 'The Price Signal by Bellwether' published in the February 2016 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.