ECONOMYNEXT – Sri Lanka’s central bank had complied with government directions as permitted by available monetary law, central bank officials said, in the wake of a controversy caused by President Gotabaya Rajapaksa slamming the central bank after summoning the Governor to his office.
Sri Lanka’s central bank was ordered to engage in a series of ‘quasi-fiscal’ activities which should have been performed by the Treasury by printing large volumes of money, on top of direct finance of the budget which had led to currency pressure and difficulties in servicing foreign debt.
Sri Lanka is now in the grip of ‘Nixon shock’ style import controls not seen since the 1970s though the country is a global leader in the fight against Coronavirus, and is a little behind Vietnam due to a reluctance to test high risk groups.
The cabinet had originally ordered 50 billion rupees to be given from the central bank (printed money), for banks to give loans.
“The proposal came originally from the government to introduce a 50 billion rupee scheme,” Deputy Governor Nandalal Weerasinghe explained responding to queries from reporters in Sinhalese.
“But there was no money allocated from the government, the Treasury. We were asked to implement it.”
Under Section 88 of Sri Lanka’s Monetary Law Act there was a provision to set up a medium and long term credit fund based on the rupee reserves available on the balance sheet of the central bank.
“Based on the balance sheet of the central bank it was a maximum of 30 billion rupees,” Weerasinghe said.
“That is how we started by allocating 30 billion. That is why we had to limit it to each bank to a certain amount in the first stage thought larger number of applications came.”
About 57 billion rupees of applications had come to the bank under the first scheme. By limiting it to a share to each bank it totaled about 28 billion rupees.
“In the second instance after a cabinet decision were told to increase it to 150 billion rupees on June 03,” Weerasinghe said.
“Again there was no assistance from Treasury.”
Weerasinghe said under Section 83 of the MLA there was a way to give short term money to banks against collateral given by banks.
The balance from the 58 billion rupees of applications was given under the second provision.
The Best Option
In the third instance banks are being asked to give loans under a credit guarantee from the central bank, in a third quasi-fiscal activity using Section 108 of the Monetary Law Act.
“Under that the central bank can give credit guarantees of behalf of the government,” Weerasinghe said.
The balance of credit directed by the cabinet of ministers would be given under central bank guarantees using money already in banks.
“That is the best solution to my knowledge,” Weerasinghe said. “If there is money the central bank will not have to pump new money.”
The central bank had cut the reserve ratio twice releasing around 180 billion rupees to banks.
Over 200 billion rupees had been printed to finance the deficit.
When money is printed – unless domestic credit weakens – foreign exchange shortages occur.
Central Bank Governor W D Lakshman said President Rajapaksa had not sought an explanation from the central bank before blaming the institution.
He said now communications channel had been set up with the government.
Quasi-fiscal activities including central bank re-finance (printing money for banks to give loans) as well as monetization of debt (printing money for the deficit) has led to the collapse of currencies, high inflation, high reserve ratios, which in turn leads to more re-finance and subsidized credit.
Sri Lanka’s central bank law was developed by John Exter an expert sent the US which gave Sri Lanka a highly discretionary central bank, which was supposed to ‘sterilize’ the balance of payments and escape the effects of commodity price fall (credit collapses of the anchor currency central bank) among others.
Though Sri Lanka’s economic troubles of foreign exchange shortages, exchange controls started less than two years of setting up the central bank other countries which used all such facilities available in the law had suffered more.
Exter also built the central bank for Philippines, which had chronic currency troubles went bankrupt partly due to quasi-fiscal activity including risks taken through forex swaps.
Eventually quasi-fiscal activities would land on the Treasury in the form of recapitalization of the central bank or reduced profits when credit guarantees materialize. However in the interim fiscal data would look better.
The central bank of Philippines had to be re-capitalized.
Economic analysts say South Korea suffered similar troubles due to a central bank set up another Fed expert, Arthur Bloomfield.
Korea reformed its central bank several times and eventually got it right in the mid 1980s shortly before a massive national strike.
“Basically these banks were set up under New Dealer influenced thinking, led by the then chief of the Fed’s Latin America section Robert Triffin,” EN’s economic columnist Bellwether says.
“Interventionists generally lionize South Korea saying subsidized credit was given, but no one asks why subsidized credit had to be given in the first place.
“In countries like Singapore and Hong Kong, interest rates were low and exchange rates were stable because their monetary authorities operated on classical economic principles.”
Korean interest rates are also low after monetary reforms.
Singapore has announced a ‘stimulus’ using forex reserves in the first instance. When money is printed and domestic credit picks up forex, reserves are anyway lost.
Analysts had warned earlier not to print money and maintain monetary stability as it would lead to downgrades.
When the currency comes under pressure, fears over debt repayments trigger credit downgrades. (Colombo/July10/2020 – Udate II)