ECONOMYNEXT – The following is republished from the opening pages of a new book by W A Wijewardena, Central Bank Independence and Other Orations as the country in on track to enact a new monetary law.
The book contains a series of lectures made by the author, over years.
The instability and economic decline in Sri Lanka and Latin America in particular came from an interventionist monetary philosophy that gained currency from the 1930s after the US Fed triggered the Great Depression a few years after coming up with a fixed policy rate.
The philosophy was relegated to fringe of economic debate in the previous century, resulting in stable money for decades on end.
Driven by Robert Triffin, a hardcore Keynesian, the US Fed helped build several central banks in Latin America and elsewhere based on a model developed in Argentina, giving economic bureaucrats almost unlimited powers to destroy money by liquidity injections.
The Fed either built anew or modified monetary arrangements drawn up by US Economist Edwin Walter Kemmerer. The new philosophy led to many central banks going off the gold standard in the 1930s, and the ultimate collapse of the US dollar and Bretton Woods in 1971-73.
Sovereign defaults and currency meltdowns began in a wave from around 1980. In the frontline was many of the central banks built by the Fed.
The philosophy helped economic bureaucrats (as well as politicians who believed in the idea) to mis-use money and destroy its use as a store of value, triggering widespread instability.
In Sri Lanka, the mis-use of money for purposes other than preserving value (re-financing of directed credit before 1990s and indiscriminate output gap targeting in the last decade, and sterilizing interventions at all times) has led to steep depreciation, growth declines and bad loans.
Whatever the motivations, Wijewardena pointed outs out that in Sri Lanka “a rupee in 1950 is equal to half a cent by 2023.”
After years of activist monetary policy, one cent coins, 5 cent coins, 10 cents coins, 25 cents and 50 cent coins are no longer produced.
Currencies collapse due to a central bank operating two anchors, one external, one domestic.
In simpler terms external imbalances come when a reserve collecting central bank keeps interest rates below the market by open market operations or standing lending facilities. Economists describe the phenomenon as the impossible trinity of monetary policy objectives.
Monetary activism to target output regained currency again after the Fed ended the so-called Great Moderation on a false deflation scare from around 2001 with ultra-low interest rates, triggering a housing bubble Great Recession eight years later.
The polices promoted in recent years have created inflation in the US and Europe not seen since the early, when the first sovereign defaults of market access countries began.
Meanwhile Wijewardena has pointed out in his new book that the new central bank bill has provisions to counter several identified problems.
Bu the new law also has provisions which will compromise its ability to deliver stable money.
Among them is the requirement to print money, if growth is below a so-called ‘potential output’ calculated by statisticians.
“In that scenario, the central bank must loosen monetary policy temporarily abandoning the strict inflation targets it is committed to follow,” Wijewardena writes.
“Since the central bank should sign a monetary policy framework at the beginning of the year with the minister of finance setting out its inflation target, any deviation from it will be construed as a failure of the bank.
“Hence, these additional provisos to the primary objective of the bank set out in the new bill will make the monetary policy operations non-workable.”
Wijewardena has also pointed out that there are no actual accountability measures in the law to deal with failures.
Given below is the full analysis of the new monetary law.
An Analysis of Sri Lanka’s New Central Bank Bill
Since the establishment of the central bank in 1950 under the Monetary Law Act that was enacted by Parliament in 1949, it was a continuous call that the central bank should be freed from the undue interferences by political leaders. The architects of the Monetary Law Act had permitted the bank to buy Treasury bills from the primary market and provide a liquidity financing like an overdraft designated provisional advances.
In 1950s, there were compelling reasons for allowing the central bank to finance the budget by buying Treasury bills and extending an overdraft facility. In this early stage, Treasury bills were issued only for a duration of three months and, hence, it was expected that they be repaid by the government automatically on maturity. Since it was not a permanent feature, it was believed that there was no risk to the bank’s monetary policy programs. Further, the extension of an overdraft facility to the government was justified on the ground that the central bank was the banker to the government, and it is the duty of the banker, among other things, to provide liquidity facilities to the customer. Again, it was believed that it would not interfere with the bank’s monetary policy since it was to be self-liquidated once the government was able to tap its revenue sources. But in practice, this did not happen. These borrowings from the central bank were permanent sources of funding for the government causing the money stock to expand unnecessarily.
The result was the tightening of monetary conditions by the central bank to keep the money stock under control. The resultant increases in interest rates and curtailment of credit were a tax on the private sector compromising its role as the engine of growth in the economy.
As a result, economic growth was recorded, on average, at low 4% trapping Sri Lanka forever in a state of underdevelopment. The increase in the money stock caused the general price level to accelerate beyond the tolerable limits.
As a result, a rupee in 1950 is equal to half a cent by 2023. Since it is the people who should suffer from the low economic growth and high inflation, it was argued in this oration that the central bank should be freed from the undue interferences of the political leaders.
The government submitted a bill in March 2023 in fulfilment of a precondition imposed by IMF for an extended fund facility to make the central bank an independent institution. The central bank should be independent not because IMF says so, but because it is in the interest of the people of the country. An independent central bank will stabilize prices enabling the people to take a longer-term view of the economy and make investment decisions accordingly. This is the essential requirement of a long-term sustainable economic advancement.
The bill is an improvement in several ways of the existing governance structure of the central bank. But it has some features which will compromise with its goal of making the central bank independent.
The following are the positive features.
Central bank as the legal person
In the new bill, it is the central bank which has been incorporated. Hence, the central bank has a legal existence, and people can take the bank to courts. In the Monetary Law Act or MLA under which the central bank has been setup, a weird situation has been created by incorporating not the central bank, but a body of people – at the beginning it was a board of three, but now 5 – called the Monetary Board leading to confusion as well as problems about accountability. This inaccuracy is proposed to be corrected in the new bill by incorporating the central bank as the legal person.
The central bank has a two-tier governance structure in the proposed bill replacing the Monetary Board. At the top, there is a Governing Board of 7 members which has the overall responsibility for the central bank. On par with the Governing Board, there is another board called the Monetary Policy Board made up of 11 members with responsibility to carry out monetary policy measures. An anomaly made there is that all members of the Governing Board are also members of the Monetary Policy Board. As a result, the monetary policy is not conducted by the central bank independent of the functioning of the Governing Board. The Governor functioning as the chairman of both boards provides further confusing link about the ultimate accountability of the bank. If monetary policy is abused or twisted, the Governing Board members are also accountable for the same, though it is determined by a separate body. Since the Monetary Policy Board has two other experts and two Deputy Governors as members, they are not accountable for the missteps taken by the Governing Board. This is not a suitable governance arrangement. All the appointed members including the Governor are recommended by the Minister of Finance to the Constitutional Council and the President for appointment. In addition, the Deputy Governors are to be appointed by the Minister of Finance, a provision newly introduced. Hence, the likelihood of those loyal to him being recommended or appointed, as the case may be, has not been eliminated.
Removal of Finance Secretary from boards
An important change introduced in the new bill is the removal of the Finance Secretary from the decision-making process of the central bank. He is not a member of either board. However, he has been given a role in the central bank as a member of a new council called the Coordination of Fiscal, Monetary, and Financial Stability Policies Council which is simply a body to share information and exchange views on macroeconomic development, outlook, and risks.
The Governor is the chairman of this council, and it is represented by the government by Finance Secretary and Secretary to the Ministry of Economic Policy, if such a ministry exists. Otherwise, it is a two-person exchange of views which cannot have a chairman. It seems that this council is a forum for the government to inform the central bank of its position, on one side, and be informed of the action and policy of the government, on the other.
There is no provision that the Governor should officially place the transactions that take place in the council before the Governing Board or the Monetary Policy Board. This communication line has not been spelt out. Further, the bill specifically says that to avoid doubts, the council has no authority to make decisions over the fiscal, monetary, and financial stability policies. This is a blurred area of governance arrangement between the government and the central bank. It is doubtful whether it will deliver any useful results.
Objectives of the bank
In the existing MLA, both the economic and price stability and the financial system stability have been made core objectives of the bank ranking on par with each other. Therefore, they are also referred to as co-objectives. This is a confusing state because it renders the bank inactive especially if financial institutions fail in an inflationary situation. To resolve inflation problem, the bank is required to tighten money flows from the bank, but to rescue distress financial institutions it should do the opposite. It is a strange situation where the bank is unable to meet either objective.
To eliminate this dilemma, in the new bill, it is specifically ruled that the primary objective of the central bank is to achieve and maintain domestic price stability reckoning, among others, the need for filling the gap between, if any, the potential output and the actual output. This situation arises only when the actual output is below the potential output resulting in the economy to underperform. In that scenario, the central bank must loosen monetary policy temporarily abandoning the strict inflation targets it is committed to follow. Since the central bank should sign a monetary policy framework at the beginning of the year with the minister of financesetting out its inflation target, any deviation from it will be construed as a failure of the bank. Hence, these additional provisos to the primary objective of the bank set out in the new bill will make the monetary policy operations non-workable.
The secondary objective of the central bank as set out in the new bill is to secure the financial system stability. What this means is that if there is a conflict between the price stability objective and the financial system stability objective, the bank should give priority to the former ignoring the latter. Accordingly, the bank’s task will be to see that the system is stable through its regulation and supervision of financial institutions on an individual basis, on one side, and ensuring macroprudential regulation of the financial system from the system’s point, on the other. In the case of failed or problem institutions, the bank should resolve them either by closing them or by infusing capital into them. Since closure of an institution is a near impossibility in Sri Lanka in the present political environment, finally, it boils down to rescuing them through new fund infusion by way of capital and/or loans.
The central bank cannot fund them if it is fighting inflation in the system. In these circumstances, it will be the government which will have to rescue these institutions. The new bill specifies that the bank should get government funds for this purpose after consulting the minister of finance who in turn is required to get the approval of the Cabinet to spend public funds to rescue an insolvent bank.
However, it presumes that the problem-ridden financial institutions are bailed out through external funding. While the details of the resolution procedure have not been spelt out in the bill, it would have been helpful if the emerging global trend in financial firm resolution, namely, getting those inside financial institutions like shareholders, depositors, creditors, and even employees to take leadership in bearing the resolution burden known as bail-ins, had been accommodated within the provisions of the bill. As it is, if a bail-in is to be implemented by the central bank, a separate law empowering it to do so need be enacted in Parliament.
Banker to government
In the MLA, the central bank is the banker to the government and so is in the new bill too. John Exter has been criticized here for permitting the central bank to invest in the primary issue of Treasury bills as well as for opening a liquidity financing facility called the Provisional Advances set at 10% of the estimated revenue of the government for the next year.
However, the new bill has debarred the central bank from granting direct or indirect credit to the government or any other public entity excepting government owned financial institutions which the central bank should lend funds under the bank’s system stability objective. Accordingly, the bank has been debarred from purchasing any security, mainly Treasury bills, from the primary market thereby putting a stop to the central bank-funding of the budget provided for in the MLA at present. Any purchase can be made in the secondary market to facilitate the central bank to conduct its open market operations as a monetary policy instrument. However, such purchases should not amount to a lending to the government directly or indirectly. Similarly, in the new bill, the granting of provisional advances has been severely curtailed as described in the following para.
New provisional advances
Special provision has been made in the transitionary provisions about how the curtailed provisional advances should be made to the government. A new provisional advance can be made by the bank in the first month of the year at the prevailing market interest rates not exceeding 10% of the actual revenue of the government in the first four months of the previous year. However, this should be repaid within six months making them truly provisional advances. This is to enable the government to commence its budgetary operations in a new financial year without disruption because of the delay in raising revenue in terms of the tax proposals in the budget. To strengthen it, the central bank can buy government securities in the primary market within the first six months of the new bill coming to operation, but they should all mature within a year. The existing debt stock owned by the central bank can be converted to negotiable debt instruments maturing within 10 years enabling the bank to sell them in the market and liquidate the same. The amount involved is about Rs 30 trillion as of end of March 2023. It is unlikely that such a volume can be disposed of in the market without allowing the interest rates to move up.
The following features introduced to the new bill need amendment if it is to serve its purpose of making the central bank independent.
It is only administrative and financial autonomy that has been spelt out>
The bill has stipulated that the ‘Central Bank shall have administrative and financial autonomy’. This refers only to the central bank’s independence to prepare its budget and run its day-to-day affairs. For instance, there is no necessity for the Minister of Finance to approve its budget or the appointment of officers below the rank of Deputy Governors. A serious gap in this provision is that it does not refer to the need for having independence to design and implement monetary policy and financial system stability policy without the interference of those in power.
This dilution of autonomy is further compromised by the powers entrusted with the Minister of Finance in recommending the Governor, six members to the Governing Board, and two members to the Monetary Policy Board to the President and finally appointing Deputy Governors who are also members of the latter board. Therefore, though the Treasury Secretary is not there sitting on the governing board or the monetary policy board, all members including the Governor of the Bank are recommended by the Minister without following any procedure laid down for it. Therefore, by appointing those who are amenable to him, he could more effectively control the day-to-day administration, the budget, and the key policies of the central bank. As a result, instead of establishing the autonomy of the central bank, the new bill has seriously diluted it.
Minister’s unnecessary powers
This serious gap could have been avoided had the Minister of Finance been removed from recommending the Governor, and board members, and appointing deputy governors. There is no case for a politician who has assumed political power for a given period recommending members or appointing deputy governors to an autonomous entity. In addition, in the new bill, the Minister is empowered to appoint an outsider also as a deputy governor. In a political culture where those in power anticipate life-long loyalty from those who have been recommended or appointed by them, such an arrangement is a threat to the autonomy of the central bank.
Hence, instead of the appointment process that has been incorporated in the new bill, a nomination and a selection process should have been introduced. In this process, a nomination committee could be appointed by the existing Governing Board or the Monetary Policy Board which should start its work well before the relevant position falls vacant. The nomination committee can invite nomination of suitable persons for the relevant posts or head hunt them by itself, subject them to a stringent screening process through informal discussions and interviews and nominate three names to the Constitutional Council for recommending one name to the President for appointment. That would have been a more objective method of appointing people on merit who do not have a loyalty to the person who have recommended or appointed them. In the case of deputy governors, the minister should not have any role in appointing them because their appointment should always be based on merit after subjecting them to a stringent screening process That power should be left with the Monetary Policy Board which knows its job much better than a politician who has got into that position for a limited period.
Appointing an outsider as a deputy governor should be based on the needs
There is no necessity to stipulate in the bill itself that an outsider could be appointed as a deputy governor. That choice is available even in the present central bank setup, though it is not specifically laid down in MLA. Accordingly, if the Monetary Board which is the current appointing authority in consultation with the Minister of Finance could do so depending on the need of the day. In the whole history of the central bank, the Monetary Board did it only once when it appointed Professor Theodore Morgan of the University of Wisconsin as Deputy Governor of the Bank in 1953.
Parachuting him from outside was done to get his expertise to design and conduct the first ever consumer finance survey by the bank and prepare the groundwork for the compilation of the national accounts. Morgan accomplished both tasks within one year and his term was accordingly terminated in 1954. Since then, the Monetary Board did not feel it necessary to appoint an outsider as the Deputy Governor of the Bank and the position was always left to the career central bankers from within. Hence, the present position which is a specific provision in the bill will enable politicians to plant someone loyal to them in the position of the deputy governor and it does not augur well for the smooth functioning of the central bank.
Monetary Policy Board
The intention of setting up a separate monetary policy board was to allow the central bank to conduct monetary policy independent of the bank’s other functions. However, the way the membership of the monetary policy board has been constituted has defeated that objective. According to the provisions of the bill, this board is made up of the Governor, six members appointed to the Governing Board, two additional members appointed specifically for this purpose and the deputy governors in charge of price stability and financial system stability. As a result, the monetary policy board has been subsumed by the governing board and, therefore, does not have an independent existence. Hence, the governing board has influence over the monetary policy board, but the latter does not exercise any influence over the former. This is a serious distortion of the governance structure of the new central bank.
The term of the Governor
Another omission of the bill is the non-specification of the term of the Governor. In the transitional provisions of the bill, it has been specified that the present Governor will be the Governor of the new central bank as well. However, he holds the position only for twelve years including the period he has already served as the Governor. But the bill is silent on the term of the new governors appointed to the central bank. This is not the case with the members of the Governing Board or the Monetary Policy Board. In their case, the term has been specified as six years and limited only to two terms. It is therefore necessary to make a like provision relating to the term of the governor as well. Since the bill cannot be changed
now, this could be done as an amendment at the Committee Stage of the debate in Parliament.
A negotiable bond for government debt
The government as at end March 2023 is indebted to the central bank for a sum of Rs 30 trillion, made up of Rs 2.8 trillion by way of investing in Treasury bills and another Rs 236 billion by way of provisional advances. These claims on the government should be transferred to the new central bank as well. However, since there is a demand for the domestic debt reorganizing, the government can selectively choose which domestic debt should be reorganized. In the transitional provisions of the bill, it has been specified that a negotiable debt instrument should be issued to the central bank for about 10 years.
This option is favourable to the government since it is freed from making interest payments, then and there, when the Treasury bills in question mature. But it is unfavourable to the central bank because it loses the important annual interest receipts. Since the interest income from Treasury bills is the main income source of the central bank to pay for its expenditure, the non-receipt of this important income will jeopardize cash flow of the central bank as against its annual expenditure programs.
The accountability of the central bank
The accountability of the central bank is more clearly spelt out in the new central bank bill than in the existing MLA. One area of accountability is the declaration of a target for the inflation which the central bank should attain in agreement with the Minister of Finance. This is called the inflation targeting monetary policy framework, quite different from the money supply and or reserve money targeting monetary policy being pursued by the bank at present. There is an underlying inflation target in the present monetary policy framework too.
In this framework, the central bank controls reserve money and through it, the money stock of the country, to maintain an underlying inflation rate. This is an ex parte action taken by the bank and there is no agreement about it with the government. At the end of the period, if this rate has not been achieved, there is an explanation by the central bank. It simply says that the inflation rate has accelerated above the underlying inflation rate in the monetary policy framework. And there is no accountability for this failure. But in the new central bank bill, the procedure relating to accountability has been clearly laid down.
Inflation targeting and accountability procedures
Once the agreement has been reached between the Minister and the Central Bank, the Minister should publish it in the Gazette within a week. Also, once in every threeyear period or even earlier than that, both Minister and the Central Bank should review the factors that have been taken into deciding on the inflation target and publicize it through the Gazette. The Central Bank is permitted to deviate from the inflation target by a margin agreed with the Minister.
But if the Bank exceeds that margin for two consecutive quarters, it should explain it the Parliament through the Minister by submitting a special report. That report should contain as a minimum the reasons for the failure, the remedial action taken and timeframe within which the bank will be able to revert to the target. But what the Parliament should do to that report has not been spelt out in the bill. This is a serious gap in the law. Every six months, the Central Bank should also publish an inflation report for the information of the public.
Improvements are not enough
These provisions in the new central bank bill are an improvement of the provisions in the existing MLA relating to the bank’s accountability. However, they are not of any use if they are confined only to just reporting of the facts. There should be a procedure for dealing with officers or board members who are responsible for the failure of the central bank. As it is, only public litigation cases filed before the Supreme Court under the violation of the fundamental rights of citizens that are available as redress.
Other than this legal procedure, there should be an internal procedure that can be adopted to deal with such procedure. This has not been spelt out in the new law.
The danger of enacting the bill as it is<.b>
The new central bank bill is an improvement over the existing MLA. However, it is questionable whether the autonomy suggested in the bill can actually be enjoyed by the central bank due to the undue powers that have been granted to the Minister in recommending Governor and other board members and appointing the deputy governors, including one from outside the central bank. It seems that the promised autonomy of the central bank is seriously compromised by these interventions.