Restoring Economies from the Persistent Pandemic - Monetary Policy Lessons from China

 

In his address to the World Economic Forum held on 17 January 2022, the Chinese President stated that “The global low inflation has notably changed, and the risks of inflation driven by multiple factors are surpassing. If major economies slam on the brakes or takes U-turn in their monetary policies, there would be serious negative spillovers. They would present challenges to global economic and financial stability, and developing countries would bear the brunt of it.”

This is an alert on impending monetary tightening widely spoken world over led by financial markets and central banks in developed countries in response to fast rising inflationary pressures since third quarter 2021. Such inflationary pressures have caused rise in market interest rates pushing central banks with no option but to lean with the markets by raising policy rates and tapering asset purchases.

Impending Global Monetary Tightening

The Bank of England has already started by raising the Bank Rate by 0.25% whereas the Fed and European Central Bank have started slowing the phase of asset purchases first by expecting to raise interest rates at any time in this year. Market expectations are that the Fed will begin in March by 0.50% rate hike and end up in a fast 2%-3% rise in total in view of the present four-decades high inflation of 7%. 

The rise in the US interest rates by 2%-3% would no doubt cause a global financial pandemic, given the position of UD dollar as the most popular global reserve currency and the global monetary turmoil experienced in 2017-18 consequent to the fast rise in US interest rates by 2% (from 0.25%-0.50% to 2.25%-2.50%).

Accordingly, several emerging market economies including Sri Lanka have prematurely embarked on the monetary tightening, despite significant pandemic related disruptions and uncertainties encountered by the respective economies. The word referred to "U-turn in monetary policies" by the Chinese President is this impending monetary tightening as against the historically loosen monetary policy pursued since March 2020 in response to the on-set of the Corona Pandemic . For example, the US Fed has kept policy interest rates at 0-0.25% with the historic increase in money printing by 105% reaching its balance sheet at US$ 9 trillion.

Further Monetary Relaxation in China on 17 January 2022

The Chinese central bank further relaxed its monetary policy in view of the low growth of 4% reported in the fourth quarter 2021 and financial stability concerns arising from the property market hard on the heel of the bankruptcy confronted by a Chinese property conglomerate “Evergrande.” 

Unlike the global monetary policy practice of policy rates-based open market operations in the short-term inter-bank market, the Chinese monetary policy is largely conducted to flow term credit provided to targeted sectors through financial institutions in view of the economic requirements. 

All monetary policy instruments such as policy rates, liquidity facilities, statutory reserve ratios and bank deposit and lending rates controls are geared to facilitate sectoral credit flows. For example, even relaxation of statutory reserve ratios is conditional upon the delivery of credit out of new reserves to identified sectors for macroeconomic objectives.

As such, the latest relaxation implemented on 17 January 2022 is as follows.

• Cutting the central bank interest rates on one-year medium-term lending facility loans (from 2.95% to 2.85%) and 7-Day reverse repos (from 2.2% to 2.1%) by 10 basis points.

• Injecting Yuan 200 bn (top up on existing 500 bn) for one year lending facility and Yuan 90 bn (top up on existing 10 bn) for the 7-Day reverse repo lending facility.

• On 6 December 2021, the central bank also reduced the Statutory Reserve Ratio by 0.50% and released nearly Yuan 1.2 trillion of liquidity to be used long-term. 

• In November 2021, it also launched a new lending facility as a “carbon-reduction supporting tool” to inject low-cost funds for firms working on green projects.

The central bank states that the stabilization of China's economy is currently under the pressure of shrinking demand, disrupted supply chains and weakening expectations since the second half of 2021, and, the central bank would widen the use of policy tools to "prevent a collapse in credit" and to stabilize the economy. 

Policy Lesson to Other Central Banks

Almost all central banks now seem to proceed with the monetary tightening in the belief of monetarist hypothesis of inflation as a monetary phenomenon. However, they accept that the present global inflation is a result of supply side bottlenecks consequent to reopening of economies resulting demand-supply imbalances after the Pandemic. As such, the present global inflation is a pandemic phenomenon never experienced before. It is believed that present inflationary pressures are persistent than initially expected until present supply bottlenecks are sorted out.

Major central banks believe that the present recovery of growth is strong on the basis of significant reduction in unemployment to levels prior to the Pandemic. However, it is now revealed that the low unemployment is also a pandemic phenomenon due to resignation of employees from the formal sector labour force consequent to pandemic-related demographic changes. 

Therefore, central banks’ tendency to tighten the monetary policies fast by following monetarist non-pandemic hypothesis will no doubt cause another Great Depression in the global economy in years to come due to high cost and shortage of credit coupled with a possible financial/liquidity crunch or crisis. The outflow of capital from the emerging market economies to developed economies will no doubt push many such economies to wide-spread economic and financial bankruptcies as already signaled from several countries.

Present Sri Lankan Context

Sri Lankan economy confronted with the monetary tightening and financial difficulties is a good case in point. Sri Lankan central bank on 19 August 2021 announced a sugar rush increase in policy rates by 0.50% and Statutory Reserve Requirement by 2% (removal of nearly Rs. 120 bn from the banking system) on concerns over possible inflation in the middle of struggle over the pandemic. This tightening has been topped up by the aggressive mop up of the liquidity by the central bank from the banking system. Further, on 19 January 2022, the central bank announced an additional increase in policy rates by 0.50% to 5.5% and 6.5%, respectively. 

Financial repercussions of such policy tightening are already seen significant from the first phase of tightening itself as highlighted below.

• First, the banking system confronts a severe liquidity shortage by pushing it to a net overnight borrower of around Rs. 400 bn from the central bank, changed from the net overnight depositor of around Rs. 50-100 bn with the central bank prior to the policy tightening.

• Second, yield rates of government securities have risen by 3%-4% casing severe debt service problems to the government. The increase in Treasury bills primary yield rates, despite the central bank’s direct subscriptions (nearly Rs. 357.6 bn since 19 August 2021) to weekly issuances, has been a little more than 3%. As result, the additional cost on average incurred by the Government/public for borrowing through Treasury bills alone between 19 August 2021 and 19 January 2022 (Rs. 1,134 bn) is about Rs. 25 bn. Whether this is justifiable in the current context is an open question.

• Third, the minimum increase in cost of credit to private sector is reflected by 2.8% increase in prime lending rate.

Therefore, such increases in interest rates would be adding to further inflation through the increase in cost of production and cutting the growth and employment by banks’ reduction in credit to avoid risks.

The reason as to why a tightened monetary policy is pursued is not established even within the central bank as central bank economists state that the present inflation is short-term while long-term inflation expectations are not seen from yield rates at bond auctions. Some even decline to accept the instability prevailing in the economy.

Therefore, the present monetary policy model pursued without any sectoral targets of finance is seen to be the major cause for disruptions in both domestic money market and foreign exchange market in Sri Lanka. 

In this context, unless the monetary policy is urgently reformed to restore the economy from the pandemic phenomenon, the present instability of the economy will be long persistent pushing the economy to a macroeconomic pandemic as the present inflation targeted in Sri Lankan monetary policy is not a monetary phenomenon controllable by the central bank but it is a global pandemic phenomenon.

As such,  the idea of the separation of current inflationary pressures between supply side bottlenecks and demand side pressures, and monetary tightening to control the demand side to match the distrupted supply side in line with the old fashion mainstream economic belief are only hypothetical exercises in the present context. Further, central banks do not have tested tools to pursue such hypotheses. 

Therefore, the proposed containment of the demand side already disrupted by the loss of employment and income sources to match the supply side distrupted by the Pandemic will no doubt shrink the economy and living standards to historic lows. As such, monetary tightening in conventional hypotheses is not the appropriate policy to promote macroeconomic stability in the present pandemic context.

Therefore, what most feasible for Sri Lankan policymakers in the present context is to keep supporting the markets by awaiting the spillovers of the ease of supply side bottlenecks in the developed world and China in years to come.

P. Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka