Central Bank booklet "Monetary Policy Implementation in Sri Lanka" - Why it is technically incorrect and unprofessional.

In July this year, the Central Bank of Sri Lanka (CB) released a publication "Monetary Policy Implementation in Sri Lanka."  

https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/P.R_20230710_The_Central_Bank_releases_a_Pamphlet_on_Monetary_Policy_Implementation_e.pdf 

The CB has a practice of issuing such short publications as Guides to specific functions of the CB to make the general readers aware of the nature of such functions. However, this publication attempts to present highly conceptual and theoretical materials that are controversial among the economists and policymakers whereas its use to general readers is very limited.

Therefore, this article does not comment on diverse texts carried the publications but highlights a few of graphical materials of the publication to establish the technical inappropriateness of the publication.

My comments are given on following 7 figures presented in the publication.

Comment 1 - monetary policy evolution

The CB never followed such different approaches of the monetary policy as presented in figure 3 above. What the CB has ben pursued are the diverse policy actions permitted in the Monetary Law Act (MLA) since 1950. In general, the objective of the monetary policy is the stabilization of the economy through the use of appropriate policy actions and targets based on exchange rates, interest rates, credit flows, foreign currency flows, money printing, money supply, etc., as authorized in the MLA depending on sources of instabilities confronted by the economy from time to time.

The areas of instabilities are the general prices, national product and income, employment and international balance of payment. Therefore, the policy evolution presented in the publication in the form of different frameworks and operating targets is meaningless. Further, CB Annual Reports should have presented them as applicable if they were really pursued by the Monetary Board.

Comment 2 - decision making process

The presentation in figure 4 above is incorrect in terms of relevant provisions and powers in the MLA. What is presented in the figure is only the internal divisions of CB operations. However, the Monetary Board and the CB Governor are the monetary policy decision-makers. Economic Research Department carries out only the research function to advise and guide the Monetary Board. Therefore, Monetary Policy Committee and Market Operations (MOC) Committee are unofficial groups. 

For example, MOC has no mandate to decide on foreign exchange operations or domestic money market operations. They all are decided by the Governor. Departments of Domestic Operations and International Operations undertake only clerical jobs. That is why officials of those Departments are not responsible for chronic liquidity problems of domestic currency and foreign currency confronted by the economy at present.

Comment 3 - open market operations

This figure 8 is grossly incorrect. CB's liquidity/money printing operations are carried out primarily based on targeting of the inter-bank overnight interest rates and not on short-term rates. The policy interest rates corridor and standing facilities window (overnight standing deposit and lending operations of the CB) are the primary sources of this liquidity managements. 

Therefore, repos, reverse repos and outright trades of securities are only residual operations to mitigate the excessive pressures in the inter-bank market. Further, the differentiation between the temporary basis and permanent basis on the liquidity management is only a hypothetical presentation and the CB does not provide separate information in this regard.

Further, all these are hypothetically presented operations and there are no statistical models or internal controls under audit to decide the preferred policy interest rates, overnight inter-bank interest rates and required liquidity.

Comment 4 - effect of SRR

The presentation of the impact of changes in SRR as presented in figure 9 is based on the old text book hypothesis of money creation on bank deposit-taking business (i.e., lending money out of deposits after allocating funds for the SRR and additional reserves at hand). 

However, in modern banking and monetary systems operating in electronic money and banking, credit is granted in bank book entries by creating deposits for borrowers whereas such deposits change hand without leaving the banking system. Therefore, deposits are created by bank credit business whereas deposits are a source of the wider liquidity management of banks among other liquidity sources such as borrowings and asset sales. Therefore, changes in SRR do not affect the ability of banks to create money/credit but affect the liquidity management. Banks also can borrow from the CB and maintain SRR in response changes in credit and deposits.

Comment 5 - purpose of OMO

The response of the teacher in the above figure is grossly incorrect. The CB conducts open market operations only for maintaining overnight inter-bank interest rates within the targets (i.e., policy interest rates corridor) through the changes in the inter-bank liquidity. Therefore, the CB does not announce any targets of wider money market interest rates and liquidity for the open market operations. In addition, the CB uses open market operations to fund the government fiscal operations too.

In the case of overnight inter-bank rates target, the immediate action is the standing facility window of the CB and, therefore, open market operation as already presented in figure 8 is only a subsidiary operation.

Comment 6 - transmission mechanism

The figure 10 is just a presentation of a hypothetical transmission of the monetary policy tools on the inflation or general prices through all other economic activities in the economy. However, the CB has never identified the time lags and the impact of policy changes on each economic sector/variable presented in the figure. Therefore, there is no any application of the presented transmission in the conduct of the monetary policy.

Further, there are several technical defects in the presentation.

• First, the supply side of the economy that determines all economic activities and inflation is left out in the presentation. Therefore, the model assumes that inflation is fully determined by the demand side of the economy.

• Second, the monetary policy also affects the supply side of modern monetary economies through credit flows to production activities. Therefore, it is incorrect to assume that the monetary policy affect inflation only through the demand side of the economy. In fact, in modern monetary economies, demand and supply cannot be separated with time lags as presented in the old monetary theory as they operate together.

• Third, the presentation of inflation expectation as the second channel of the monetary policy to determine the inflation is highly exaggerated as nobody has any research to establish that monetary policy actions guide inflation expectations of the public in real economies. The assumption behind this is that the general public believe the monetary policy as the inflation buster and, therefore, they use the inflation target announced in the monetary policy as the expected inflation for their economic activities. This is a grossly incorrect presumptuousness as there is no real world data to prove that the inflation is always controlled by the monetary policy. The best example is the four-decade high inflationary pressured confronted by the global economy during the past two years.

• Fourth, the CB's objective required in the MLA is not the inflation control as presented in the above incorrect transmission figure, but is it is the wider stability of the economy covering economic and price stability and financial stability. Therefore, the CB cannot manipulate monetary policy actions as it wishes which exposes the economy to different crises such as the present foreign currency and debt crisis.

Comment 7 - effects of policy interest rates

The presentation given above to highlight the impact of policy interest rates is grossly incorrect. Policy interest rates are risk free interest rates of the CB on its secured overnight credit operations with banks. 

However, interest rates on deposits and borrowing/lending in the banking system are determined by pricing of risks associated with underlying monetary/credit transactions. As such, changes in policy interest rates do not change bank risks involved in depositors and borrowers. Such risks are determined by factors outside risk free policy interest rates. 

Therefore, depositors and borrowers do not behave in the manner presented in the figure and they are even not aware of policy interest rates. However, banks may tend to change deposit and lending interest rates in response to changes in policy interest rates if the CB passes unethical threats to banks.

The purpose of policy interest rates in fact is to influence overnight inter-bank interest rates through standing facilities.

Concluding Remarks

This booklet is the real evidence for incorrect premise presumptuously used by the CB for the conduct of its monetary policy. Therefore, the failure of the monetary policy to stabilize the economy as evident by the present economic crisis is not a surprise.

Therefore, relevant authorities need to assess the contents of such public documents and ensure that policy authorities perform their public duties as provided for in relevant legislations in the public interest only, irrespective of their presumptuous objectives and operational models.

(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 12 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)