The CB abandoned or lost its monetary policy? Is it another IMF move?

 

It was reported that, on the first working day of the new year 2023, the Central Bank of Sri Lanka (CB) issued a new rule on open market operations (OMO) for licensed commercial banks to be effective from 16 January 2023, as follows.

• Limiting the Standing Deposit Facility (SDF) to any bank to a maximum of five times/days for each month.

• Limiting the Standing Lending Facility (SLF) to any bank to a maximum of 90% of the Statutory Reserve Requirement of each bank on any given day.

Therefore, this short article is to highlight that, with this new monetary policy rule, the CB loses not only its key monetary policy instrument but also monetary policy as a whole. This raises serious concerns over the fitness and propriety of those in the CB who make public policy decisions and implement them.

Policy Interest Rates

The key monetary policy instrument used by all central banks in present monetary policy models is the interest rate announced by them for their overnight lending operations with banks to decide the extent of money printing. However, central banks use this policy rate model differently.

• Some central banks, i.e., the Bank of England, announce only one rate for overnight lending or deposit operations with banks (i.e., Bank of England, 3.50% at present).

• Some central banks announce two rates for overnight operations, i.e., one rate for lending and another rate for deposit/borrowing (i.e., European Central Bank, 2.0% and 2.75% at present).

• The US Fed announces a target rates range for inter-bank overnight loans (federal funds rate target, 4.25% - 4.50% at present).

All these policy rate models are to set limits for variation of inter-bank overnight lending rates. Therefore, this policy strategy is known as interest rate targeting. Through such policy rates, central banks expect to control inflation of the economy around targets.

Globally, the major monetary policy decision is the announcement of the policy rates. All interest rates and credit operations in the economy are expected to change, accordingly, to drive the economy towards target of inflation.

Central bank monetary operations known as OMO (funds injection to and absorption from the banking system) are carried out to ensure that the overnight inter-bank rates are within such policy rates or targets. Therefore, policy rates serve as the ground for present OMO known as active OMO. As central banks can print any amount of money it wishes, they can set any policy interest rates they prefer, unlike in other price controls imposed by bureaucrats.

Policy Interest Rates of the CB

Policy rates of the CB operating since 2013 are the Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) followed from the European Central Bank model.

• SDFR is the interest rate paid by the CB on overnight deposits placed by commercial banks at the CB. It is 14.5% at present. The total SDF amount is Rs. 337 bn today.

• SLFR is the interest rate charged by the CB for overnight borrowing of commercial banks against the collateral of government securities from the CB. It is 15.5% at present. The total SLF amount is Rs. 547 bn today.

Therefore, SLFR-SDFR is the rates corridor set by the CB for the inter-bank overnight interest rates. Therefore, SDF and SLF are a major part of OMO. Accordingly, the CB is ready to lend to or absorb from banks any amount of funds/liquidity at those rates to keep inter-bank rates in the corridor. 

In addition, the CB conducts auctions of repos and reverse repos on overnight and term basis in government securities depending on the liquidity levels in the banking sector to ensure that inter-bank interest rates are within the targets preferred by the CB. Therefore, overnight inter-bank rates do not move beyond the policy rates corridor.

Impact of the CB's New OMO Rule

This is a major deviation of market-based monetary policy model adopted by central banks worldwide. As a result, the CB’s key monetary policy rate instrument will be lost due to the following reasons.

• The limit of SDF will result in inter-bank rates falling below the SDFR as the excess liquidity is high in the banking system and banks will try to lend excess funds in the inter-bank.

• In contrast, the limit of SLF will raise inter-bank interest rates above the SLFR when banks try to borrow from inter-bank as banks are unable to access the CB. It is possible that inter-bank rates will rise very high as inter-bank trust seems to be very week these days as shown by marginal volume of inter-bank lending. Further, inter-bank rates have remained at the top of the corridor, 15.5% (SLFR), in recent months due to the shortage of liquidity in the market.

• Further, limiting the SLF to 90% of the SRR of respective banks has no basis in terms of market-based principle of the monetary policy as SRR is not a market liquidity indicator. The SRR is only a baseless administrative control and it does not serve as a reference or denominator to determine another operation or variable.

• It is possible that the new rule is intended to create a monetary space for funding the government through banks and CB for enhanced profit at yield rates around 32%.

Therefore, volatility and uncertainty created by the new OMO rule in the banking system will be significant unless the CB unofficially forces banks to adhere to the policy interest rates like in the case of guidance exchange rate at present. The divergence from the policy rates corridor will facilitate the CB to conduct arbitrarily targeted OMO on overnight and term basis to assist daily liquidity management of their favorite banks.

Therefore, if the objective of the CB through the new rule is to facilitate market-based interest rates, the CB should have removed the corridor fearlessly and intervene through repos and reverse repos only when inter-bank rates rise or fall detrimental to the monetary stability. That policy would serve the public better than the present confused, bureaucratic policy.

Further, if the objective of the CB is to get the market to raise lending rates and reduce deposit rates, the CB should have done it transparently through the monetary policy by raising SLFR and reducing SDFR with a broader corridor. Therefore, such hidden, bureaucratic actions are not warranted in present market-based monetary policy models. 

Present policy rates-based OMO also are open to primary dealers. Further, in 2017 the EPF also was given access to SDF. Therefore, it is not clear how the new rule will apply to the SDF on them and the SLF for primary dealers as SRR is not applicable to primary dealers. 

Further, the CB offers interest free intra-day liquidity facility (ILF) for all payment system participants. They use this facility immensely to carry on daily money business. Therefore, banks will increasingly resort to this facility in place of the SLF. The total ILF was Rs. 50.1 trillion (daily average Rs. 215.2 bn) in 2021 as compared to Rs. 15.8 trillion (daily average Rs. 66.9 bn) in 2020. It is possible that the total ILF could double in 2022, given the tight monetary conditions and lucrative investments in short-term government bonds. The new OMO rule will further boost the ILF volume in 2023 to fund banks and dealers with interest free money printing.

However, the new SDF rule will significantly cut the money printing involved in payment of interest to banks on excess liquidity. For example, interest paid in 2021 at rates of 4.50% - 6.50% on SDF was Rs. 5.7 bn in 2021 and Rs. 6.8 bn in 2020. In 2022, it might exceed Rs. 10 bn at rates of 13.5% - 14.5% paid since April on SDF mostly ranging from Rs.100 bn - 350 bn. 

Meanwhile, interest income to the CB on SLF may decline as if the SLF volume will be lower. The SLF daily volume in 2022 has declined from around Rs. 800 bn to around Rs. 600 bn towards the end of the year. At present with SRR of 4%, the SRR amount in the banking sector is about Rs. 350 bn - Rs. 400 bn, the SLF will fall to around Rs. 315 bn - Rs. 360 bn as compared to Rs. 547 bn reported today (3 January 2023).

Past Experience

The CB imposed a similar rule on SDF in September 2014. Accordingly, SDF was restricted to three times a month at the SDFR (6.5% at that time with SLFR of 8.0%) where a lower SDFR at 5% was stipulated for any use of SDF in excess of three times a month. The CB expected banks to lend more rather than parking their excess liquidity at penal SDFR.  

However, that did not happen and, as the banking system had flooded with excess liquidity around Rs. 250 bn - Rs. 350 bn at that time, the overnight inter-bank interest rates fell closer to 5% of special SDFR. As a result, the effective policy rates corridor was 5%-8%. 

This 5% special SDF rule was removed on the advice and recommendation of the present CB Governor as the then Deputy Governor on monetary policy on 27 February 2015, effective from 3 March 2015, without the prior approval of the Monetary Board. As a result, inter-bank rates rose immediately above 6.50% SDFR consequent to the removal of the 5% rule supported with the sudden moping up of bank excess liquidity by Rs. 55 bn through overnight repo (Rs.10 bn) and 7-day repo (Rs. 45 bn) auctions decided abruptly.

The policy model amendment stated above is also one that goes beyond the OMO Operating Instructions of the Domestic Operations Department as it invalidates the present policy rates based monetary policy approved by the Monetary Board. Therefore, this new rule also raises serious concerns over internal policy governance of the CB. 

As indicated in the policy change on 27 February 2015 above, policy instruments are likely to be abused internally without the knowledge of the Monetary Board, given the excessive powers concentrated in the Governor. 

Therefore, as there is no communication on the above new rule as a part of monetary policy decision by the Monetary Board, the general public deserves receiving a public policy communication from the Monetary Board without delay.

New CB interest rate on emergency lending facility

The CB also has announced the Bank Rate as the interest rate charged on emergency lending (Lender of Last Resort - LOLR, MLA section 86) to commercial banks with effect from 3 November 2022. Accordingly, the Bank Rate will be Average Weighted New Deposit Rate (AWNDR) plus 7%. From John Exter to 1999, the Bank Rate was the policy interest rate used in the monetary policy. It was the interest rate charged by the CB for short-term loans to banks against collateral of government securities for monetary policy purpose and not considered as the rate for LOLR.

However, in 1993 overnight repo rate was introduced with active/auction-based OMO for monetary policy purpose.  Further, in 1997, overnight reverse repo rate also was introduced as a policy rate to operate with overnight repo rate as policy rates corridor. This corridor was replaced with SDFR and SLFR in 2013. However, the Bank Rate also was revised from time to time without any practical applications for monetary operations.

Therefore, a formal announcement for LOLR at this stage must be considered as a significant policy decision as banks’ financial conditions have been severely worsened by the present economic crisis, loan defaults, high interest rates and public debt restructuring. In that context, the interest rate on LOLR at AWNDR plus 7% could be too high to resolve liquidity panics in the financial system. 

In crisis times, LOLR is offered at highly concessionary rates with acceptable collaterals depending on banks in trouble/crisis and the severity of the financial panic imminent that directly threatens monetary and banking stability as provided for in the MLA. Therefore, the newly announced Bank Rate as the emergency lending rate by the Domestic Operations Department is an abuse of the authority of the Monetary Board.

Although the CB states that the Bank Rate is an administratively determined rate, all interest rates including policy rates and other rates in the CB are such administratively or arbitrarily determined rates because the CB does not have macroeconomic models or economic benchmarks to determine them. The CB only can explain them in macroeconomic rhetoric rarely understood by others.

IMF Advice?

As present monetary and fiscal instruments are implemented as part of IMF conditionalities for 2.9 bn USD facility, these monetary policy model amendments also should be IMF-sponsored ones.

Although the IMF generally goes by market principles and private market development, it is difficult to understand how the IMF has changed its macroeconomic management principles and values to bureaucratic rule-based values for Sri Lanka.

Final Comments

By looking at recent policy developments in the CB, it is seen that the CB has lost its monetary policy empowered in the Monetary Law Act (MLA) after nearly 8 moths of sky-rocketed interest rates (government securities at 32%) and money printing liberally to fund the government after default of foreign debt. 

• As highlighted above, the major monetary policy model with instruments (policy rates and OMO) is now lost. Anyhow, this policy model is in violation of the MLA and not appropriate for Sri Lanka, given its recent and current macroeconomic requirements.

• Foreign reserve and exchange rate stabilization functions have been lost since the end of 2021 pushing the country to bankruptcy. 

• Only money printing liberally continues to fund the government through direct/arbitrary purchase of Treasury bills outside public auctions (historic Rs. 2,598 bn of outstanding as at today) in violation of the MLA.

Therefore, the CB is now incapable of securing its objectives, i.e., economic and price stability and financial system stability, mandated in the MLA as it has lost all major policy instruments. The latest GDP growth deteriorated to negative 11.8%, inflation at 65% historic high, currency depreciation by nearly 80% with the collapse of the foreign currency reserve, sky-rocketed interest rates with government securities at 32% and default of foreign debt are the evidence for significant instability of the economy confronting on all fronts.

In that context, the government and Minister of Finance are responsible under the MLA to ensure that the CB follow its monetary policy transparently for greatest advantage of people of Sri Lanka within the provisions of the MLA despite the CB’s new strategy of seeking religious blessings surrounded by the media for CB policy actions to stabilize the economy by controlling inflation and to reduce interest rates in the new year. No need to mention that such blessings have no correlation with the monetary policy instruments and the fulfillment of the CB’s objectives as set out in the MLA.

Overall, the policy direction and principles of the CB are seen lost to the level of seeking religious blessing to boost policymaking morale, not second to recent political leaders.

Therefore, it is not surprised if the IMF will privatize the CB to the Monetary Board and others in the CB through its proposed new Central Bank Act for Sri Lanka to find a testing ground for a new central banking model under the cover of the staggering carrot of 2.9 bn USD.

It is surprised that internationally trained economists of the CB do not understand the impracticability of  such beauracratic monetary actions to reduce inflation and bailout the bankrupt economy.

These ad hoc monetary policy actions are like change of the pillow for the headache as A S Jayawardene once commented on the present Monetary Policy Committee based monetary policy strategy.

 (This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles published. 

The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)