New Central Bank' Monetary Policy - To serve private financial firms?

This fourth article in the series on the proposed Central Bank bill is to explore its legal provisions on the monetary policy.

A careful review of new provisions show that the architects of the new bill, unlike John Exter who was the architect of the Monetary Law Act (MLA) and first Governor of the Central Bank of Sri Lanka (CB), have no idea of the purpose of the monetary policy or the central bank of a country.

This article highlights that the proposed bill disconnects the monetary policy framework from the macroeconomic management and governance system as well as from mainstream economic principles and is likely to disrupt the country's monetary system.

How the purpose of central banks evolved

At the origin, central banks were private commercial banks that gained the leading market position as the banker to banks where all banks printed own branded currency notes and coins in the monetary unit prescribed by the government for transactions as money. Such private currency based financial systems confronted frequent crises and panics due to failures of reckless banks.

Later in 20th century, state central banks were established to unify bank currencies into the state currency as the legal tender issued by state central banks with the sole authority to issue the currency on behalf of the government whereas all state central banks were legally empowered to continue as the banker to banks including bank check clearing facilities and lender of last resort to banks plus the official banker to the government. 

As such, the original purpose of establishment of state central banks were to maintain the stability of the monetary system, i.e., money and banking. For this purpose, central banks also were given the public powers to regulate and supervise banks to ensure the prudence of banking business. Accordingly, establishment of state central banks was intended to ensure that economies with state money perform with greater stability in the interest of the general public. As such, money became a public good or service regulated by state central banks in line with state policies.

The monetary policy was only a byproduct of the state money to ensure that money is distributed through credit to suit the monetary needs of public and production sectors of the economy. Meantime, theoretical versions of the monetary policy for objectives such as price stability, economic stability and maximum employment were introduced to central bank statutes in recognition of the macroeconomic role of money believed by economists under various concepts and hypotheses. 

However, such economic theories are not a part of the statutory provisions applicable to central banks whereas officials of central banks have been given the public discretion to drive operations of central banks within the prescribed provisions. Therefore, economic theories and concepts used by central banks vary from time to time depending on central bank officials. For example, even in central banks in developed market economies, there is a division between the "Hawkish" school and "Dovish" school whereas a new school has emerged as "Modern Monetary Theorists".

The Hawkish is biased towards impact of money on prices in the economy whereas the Dovish is biased towards impact of money on production and employment generation. Modern monetarists advocate for the practical importance of money for production capacity and social growth driven through the fiscal instruments.

Because of the influence of theoretical economics, the monetary policy line of central banks has become dominant over other operational lines such as currency operations, agency services, banking services and regulatory services which are practically more important to the activities of the general public and the economy.

Foundation of monetary policy

• Macroeconomic Basis

Unlike in economies without money or barter systems, money is a great invention by markets to drive economic activities more efficiently and productively by money going between economic activities with its functions, i.e., medium of exchange, unit of account or valuation, liquid store of wealth/value and deferred payment instrument.

Accordingly, modern economies operate through interactions between real side and money/monetary side domestically and internationally. Therefore, given the economic role of money, it is believed that the real side could be intervened or driven by the monetary side to achieve public economic welfare from production, employment, investment, consumption and savings. This is how the monetary policy of central banks comes into play as a macroeconomic management tool.

John Exter in his report on the establishment of the central bank in Sri Lanka in 1949 wrote "The importance of money and credit in a modern economic system hardly needs to be argued. Perhaps no single factor can do more to influence the welfare and growth of a community than the flow of money. It is the mechanism by which resources of a country can be mobilized for production. It plays a dominant role in determination of prices, wages, of income and employment. Stable money is essential to performance under contracts and to the equitable liquidation of debt; it is life blood of foreign trade."

• Operating Conduits

The money is created through credit and circulated/distributed through banking system. Therefore, the printing of money and regulation or control of bank credit by the central bank are the core conduits in monetary policy. As the money flows through banks and monetary policy transmits through banks, it is essential that banks operate in safe and sound manner without getting into systemic panics or crises.

Therefore, central banks also are given public powers to regulate and supervise banks to ensure their safety and soundness on prudential grounds so that public can deal with banks with a greater confidence. Therefore, monetary regulation and prudential regulation of banks go hand in hand for management of the monetary side of the economy for objectives relating to the real side of the economy with a view to achieve public economic welfare targets.

• Policy Instruments

Central bank balance sheet (composition and volume of assets and liabilities), bank reserves, direct credit controls such as reserve ratios and volume and direction of bank credit products and prudential requirements on bank assets and liabilities are considered as major policy instruments.

As such, the foundation of the monetary policy is the management of the monetary sector (i.e., money and banking) for the purpose of managing the real side of the economy in the interest of real public economic welfare. The policy transmission is the concept used to identify the effects of policy instruments on public economic welfare objectives over the time.

Monetary policy framework of the MLA in Sri Lanka

Some of key areas of the policy framework provided for in the MLA are listed below.

• Sections 2, 3 and 4 - Prescription of the standard unit of monetary value in Sri Lanka as the Sri Lankan rupee, powers to determine the par value and parity (exchange rates) of the rupee and the use of the rupee in all obligations and contracts.

• Section 5 - Responsibility of the CB to achieve objectives on equal footing with a view to encouraging and promoting the development of productive resources in Sri Lanka as far as possible through public powers given by the MLA. Objectives are economic and price stability and financial system stability.

• Section 8 - Monetary Board to determine policies and measures (monetary policy and others) permitted under the MLA to be responsible for operations of the CB.

• Section 48, 60 and 62 - Creation of means of payment by way of currency notes and coins as the legal tender and demand deposits denominated in Sri Lanka rupee and are subject to payment in legal tender upon demand and definition of money supply to be used in monetary policy.

• Chapter IV - National monetary policy to regulate the supply, availability, cost and international exchange of money for domestic monetary stabilization and international monetary stabilization in compliance with underlying governing principles and rules. Accordingly, both domestic monetary unit and foreign monetary units are exchanged inside the country and covered in the monetary policy.

• Accordingly, detailed provisions covering principles and rules are available in the MLA to determine and regulate the country's monetary conditions through policy instruments, manly, credit operations with banks and government, regulation of bank reserves and credit, determination of exchange rates and regulation of foreign exchange operations of banks and open market operations in government securities and CB securities.

• In addition, the Department of Bank Supervision with the Director of Bank Supervision is created to supervise the banking business on prudential grounds whereas the Department of Economic Research with the Director of Economic Research is created to guide the Monetary Board and the Governor on policies. Both carry independent mandates and discretions.

• Provisions are are available to ensure checks and balances between the government policies and monetary policies. Reporting to the Minister of Finance in times of monetary and foreign exchange instabilities to coordinate policies, functions of the CB as fiscal agents, agent, financial adviser and public debt manager and powers of the Minister to issue directions to the Monetary Board on the national monetary policy in times when views of the Minister and Monetary Board are dissident. However, the Monetary Board is fully independent in taking monetary policy decisions with the majority votes even if the Secretary to Ministry of Finance as a member opposes.

Accordingly, the framework provided for in the MLA for the conduct of the monetary policy is broadly to regulate monetary conditions in the country through CB's credit and foreign currency operations with commercial banks, regulation of bank credit and CB's credit operations with the government, i.e., provisional advances and government securities.

However, the printing stage of money is primarily the central bank credit operations with the government. This is the global central banking practice followed even in the advanced/developed market economies. The reason is to minimize risks of private credit on money printing.

In summary, the framework provides for official monetary unit, legal tender as means of payment of money, the volume of money and direction or distribution of money as required from time to time to suit the monetary needs of the economy and sectors to support the real sector.

Accordingly, the CB has a package of policy instruments to resolve economic problems confronting sector-wise economic activities simultaneously and to distribute credit and monetary resources to maintain a greater balance in development of economic sectors based on mobilization and promotion of resources in respective sectors of the economy. The monetary policy is the main conduit in this regard.

Monetary policy framework of the proposed Central Bank Bill

The new bill provides for limited monetary policy instruments whereas the policy framework is a clear disconnect of money and credit from the sectors and the economy. Therefore, the monetary policy is only another state bureaucracy line with a micro perspective. Glaring provisions with public issues raised in the context of macroeconomic management are listed below in 6 categories.

1. Official unit of monetary value lost

As relevant provisions in the MLA have been repealed, there is no prescribed monetary unit in Sri Lanka to serve functions of money whereas only legal tender or currency is provided for in the bill. Grave issues are;

• The present monetary and payment system will collapse due to confusions in their legality without an official monetary unit.

• The monetary policy will be defunct as only currency is available in the economy without official money or monetary unit.

• People can use private monetary units or foreign monetary units to serve functions of money as there is no prevention in the bill unlike in the MLA.

2. Objectives of the CB

Section 6 provides for domestic price stability as the primary object and financial system stability as the other object. Key comments are as follows.

• The separation between the two objects as primary and other is not practical as both are inter-dependent and the monetary policy is the main policy framework available to secure both objects.

• Policy powers to secure objects are not explicitly provided for or not recognized in the bill unlike in the MLA.

3. Credit and open market operations

• Section 31 - The CB will conduct credit operations with banks, finance companies and leasing companies.

• Section 86 - Credit operations with the state/government have been prohibited.

• Section 87 - Credit operations with credit institution as agent of the government.

• Section 36(6) - The LOLR in times of disturbance and issues of financial system stability will be provided only on government guarantees.

• Section 11(1) -  The Monetary Policy Board is responsible for formulation of monetary policy and implementation of flexible exchange rate regime in line with the flexible inflation targeting framework in order to achieve and maintain domestic price stability.

• Section 11(2) - The Monetary Policy to regulate the supply, availability, and cost of money, taking into account the macroeconomic and financial condition of Sri Lanka.

These provisions will disrupt the standard monetary policy operations of the CB followed from other central banks.

• Central banks generally conduct credit operations through banks which are well regulated and supervised by them to ensure a greater credit distribution and smooth policy transmission across the economy without involving significant risks. However, the inclusion of other financial institutions (shadow banks) lying on the outer perimeter of the financial system with a high degree of business risks exposes the monetary policy, the CB and the economy to undue business risks.

• The prohibition of credit, direct and indirect, to the government prevents a risk free conduit used in monetary policy to channel risk free monetary resources across the economy and sectors. Therefore, the new CB will become a central bank for risky financial institutions.

• Open market operations will have to be conducted on the trade of private securities such as debentures, shares and other private debt instruments as the trade of government securities is not available due to prohibition of purchase of government securities in both primary market and secondary market (indirect credit). This provides the avenue for the CB to get exposed to and the monetary policy to depend directly on private financial market risks. This may be good to develop private financial markets, but the dependence of the monetary system directly on such markets will cause systemic risks and insolvencies to both the financial system and CB. In central banking across the globe, government securities is the instrument used in the monetary policy to regulate the monetary liquidity and market interest rates through fixing the yield curve as appropriate through open market operations. However, as this instrument is lost, it is hard to think whether the new CB will use the stock market securities for this purpose.

• Conventional LOLR powers have been withdrawn. Accordingly, financial system stability during distress and panic situations can be protected only if the government provides credit guarantees to the CB for that purpose. New provision has empowered to bailout risky or reckless shadow banks through the government guarantees. This poses undue responsibility to the government or public funds to socialize private financial risks of financial institutions that are regulated by the CB. This is morally inappropriate and unethical. If this was the LOLR position at the US Fed, the country today would be confronting a financial crisis due to the collapse of of three banks in the US last week, i.e., Silvergate bank on 8 March, Silicon Valley Bank, 16th largest bank in the US, on 9-10 March and Signature Bank on 12 March, which would have been worse than that happened in 2007/09 unless the Fed had emergency lending powers to banks. The Fed on the Sunday (12 March) announced additional funding up to 12 months without limit to meet liquidity needs of all types of banks and financial institutions on the face value of government securities, agency mortgaged backed securities and other qualified securities pledged as collaterals. It appears that this monetary policy action of the Fed has pre-empted a major financial panic envisaged.

• Refinance credit and sectoral bank credit regulation powers used extensively for development and credit distribution have been withdrawn. Therefore, the CB does not involve in credit distribution activities under the monetary policy. Refinance credit has played a significant role in monetization and development of the economy until the beginning of 2000 which was phased out by the CB under the modernization program implemented on the advice of the World Bank and IMF. Now, refinance  provisions also are removed from the statute while introducing it as an agency function.

• Agency function of credit out of government funds assumes that credit distribution is a function of the government and not an instrument of monetary policy. The government does not require such a credit agency function from the CB as it has a state banking network. In fact, a large number of credit schemes beneficial to the economy and public groups has been implemented by state banks.

• Flexible exchange rate regime and flexible inflation targeting framework are highly theoretical concepts which are not interpreted in the bill and, therefore, provide opportunity for CB officials to abuse such terms to facilitate interested parties. Such controversial concepts are not used even by central banks in advanced market economies. The section 11(2) conflicts as the regulation of the supply, availability and cost of money is to be carried out by taking into account the macroeconomic and financial condition of Sri Lanka and not for domestic price stability stated in the monetary policy. As there is no official monetary unit or money other than the currency as the legal tender, the Monetary Policy Board has to regulate the supply, availability and cost of the currency as money under its monetary policy.

4. Inflation targeting framework agreement with the minister

The section 26 provides for the Minister and the CB to sign a monetary policy framework agreement with regard to setting out the inflation target to be achieved by the CB and to review the inflation target and any other parameters relating thereto, once in every three years or in such other intervals, if exceptional circumstances so warranted.

• This is the loss of monetary policy independence although Minister's intervention under section 116 of the MLA has been removed. At present, the Monetary Board has the full independence for the monetary policy decision where the MLA section 116 intervention has been very rare.

• The report presented to the Parliament through the Minister in instances of missing inflation target during two consecutive quarters under section 26(4) is useless as it would be a theoretical and bureaucratic report and the Parliament cannot take any decision to punish or intervene in the Monetary Policy Board.

• Similarly, submission of report to the Minister during anticipated economic disturbances and endangering domestic price stability under section 28 is also useless whereas proposing fiscal measures to the government is unethical as the domestic price stability is the responsibility of the independent CB.

5. Foreign exchange operations

Foreign exchange operations provided for in Part VI of the bill cover the CB to deal in foreign exchange, maintain a foreign reserve and determine working balances in foreign exchange of banks. Major issues in these operations are as follows.

• There is no macroeconomic or monetary purpose specified in these provisions. Therefore, it appears that foreign currency operations of the CB are just a profit-seeking business line like in banks.

• Although section 7(1)(b) provides for the CB to determine and implement the exchange rate policy and section (11)1 provides for implementations of flexible exchange rate regime, there are no any specific provisions relating to exchange rates although exchange rate is a monetary price globally used in the monetary policy. Therefore, a large number of principles and rules has been provided for in the MLA on foreign exchange operations. In fact, the preset CB Governor abuses them to appreciate the currency for political objectives against macroeconomic fundamentals of the present Sri Lankan economy. However, almost all provisions have been repealed in the new bill.

• In the new bill, the CB has no role in exchange rates, probably because there is no Sri Lankan monetary unit to be traded against foreign monetary units.

6. Independent economic research and bank supervision withdrawn

Those two statutorily established by the MLA and other departments in the CB that provide technical services to the conduct of the monetary policy have been repealed. Further, there are no provisions in the new bill to establish departments in the CB. Therefore, the monetary policy framework has lost checks and balances and essential technical services system. 

Especially, non-availability of an independent bank supervision and resolution mechanism in the bill will risk the banking sector soundness essential for monetary policy and its transmission. The macroprudential authority introduced by the bill is only a highly conceptual approach to regulation and supervision which has failed world over.

Macroprudential is the regulatory approach followed on the basis of systemic risks detected from financial system's aggregate data and to act accordingly to prevent system-wide risks. However, aggregate data are dominated by large banks and, therefore, imposition of new regulations to all banks to address new risks caused by dominant banks are unjustified. Therefore, what is required for the system stability is the conventional microprudential approach to deal with individual banks and institutions as and when concerns are raised. It is often reported that regulators fail on microprudential approach too. As such, macroprudential is nothing but the change of the pillow for the headache.

Further, getting excessively risk-taking shadow banks to the new regulatory and supervisory system at par with commercial banks under the hypothetical macroprudential approach is an act of excessive moral hazard spread across the financial system.

In this perspective, the recognition of financial sector participants covering all types of financial service providers including stock exchanges, stock brokers, insurance brokers, fund managers and market intermediaries under macroprudential framework in the bill poses a conduit for excessive moral hazard where the CB will find a conduit for bailing out them as well.

Concluding Remarks

As highlighted above, the public and economy will loose the national monetary policy that serves to ensure a greater distribution of money and credit, sectoral balances including domestic and external balances and monetary system stability of the country in public interest. The foundation of the MLA is for that kind of monetary policy and a central bank.

Instead, the monetary policy under the new bill is to promote risky shadow banking business by giving financial access of the monetary policy and money printing to shadow banks. This is not seen even in central banks of advanced market economies. Therefore, the MLA version of the monetary policy including the national monetary unit and monetary system has been repealed by the new bill.

Therefore, the new CB will not only disrupt the present monetary system but also be dysfunctional due to conflicts and fundamental lapses among statutory provisions.

It is surprising why the authorities present such an unpublic and controversial bill to the Parliament as a part of conditions to receive a loan of US$ 2.9 bn from the IMF whereas the macroeconomic loss to the public from the implementation of the new bill will spread over generations as the country looses a macroeconomic based monetary policy that has been tested for 72 years. 

It is well established that the present economic crisis emanated from the policy failure of the CB is not because of lapses in provisions of the MLA and monetary policy framework but because of professional lapses of those who were responsible for implementation of the MLA. In fact, the group of CB officials who present and market this bill as the God-given policy model to rescue the economy and public from the present crisis is among those who have failed to perform. Therefore, the new bill is intended to cover up there failures as the MLA based CB will be repealed by the new bill.

It is reported that several individuals have already made FR Applications to the Supreme Court. It is important that facts are presented how the new bill is detrimental to the macroeconomic governance of the country and to economic wellbeing of the general public also in addition to legal principles relating to non-compliance of the bill with the Constitution. What matters is the loss of the institutional framework already set up and enjoyed under the Constitution in the public interest than envisaged or predicted outcomes of the new institutions in place of existing ones.

Such enactments made in haste during public instabilities are always subject to abuses and insider motives. Lawmakers who do not have any idea of technical subjects behind proposed enactments just vote to show the political strength of the party/group despite grave consequences to the society. Therefore, this bill also will get the political vote without much difficulty in anticipation of IMF support sold for the bill. The public has to wait for lasting consequences soon.

(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 publish. 

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)