Economy's Recovery - Whose responsibility? Government or Central Bank? Who should fund it and how?

Background of the article

In last last two years the media has been full of analyses on what caused the country's economic crisis in modern history, who were responsible for and what policies are necessary to recover the economy. While all these analyses are presented on a micro set of information, the common feature has been to blame each other who governed the country in the past several decades inter-changeably or in political coalitions. In such blames, the state corruption is presented as the cause of the crisis.

I also wrote several articles to this blog and published a book (Sinhala medium) (2022 ශ්‍රී ලංකා ආර්ථික අර්බුදය ආර්ථික විද්‍යා ඇසකින් - අර්බුදය වැලැක්වීමටත්, නිරාකරණයටත්, අප අසමත් වූයේ ඇයි? අර්බුදයේ දෙවන වටයට සූදානම් වෙමු ද?) in July this year based on macroeconomic management information available to me.

Now awaiting for elections next year, political leaders have commenced enumerating heart-felt livings difficulties presently confronted by the public and making various promises to the public how they will bring the prosperity and national security back to the nation. 

Meanwhile, the government in power states that the country is kissing the near point of coming out of the bankruptcy, thankful to the IMF loan of US$ 3 bn and its conditionalities complied with by the government despite their national pains. Accordingly, the authorities affirm that the economy is now on track for the recovery.

All these promises and affirmations are based on various micro or sectoral information of their preference picked from the failed macroeconomic management models pursued in several decades. 

However, none seems to propose any specific macroeconomic management model for such recovery and prosperity other than verbal fabrications for creating haven-like living conditions if they are given the power. Nobody seems to have any idea of how they find money to finance their proposals in present market-based monetary economies. 

Therefore, this article briefly presents a recommendation for a credit distribution policy suitable for providing funds to sectors and activities that are instrumental in the proposed recovery and prosperity.

Economic crisis in a nutshell

Sri Lankan economic crisis was primarily a foreign currency crisis that owes to the global Corona pandemic and mismanaged monetary policy of the central bank in the past two decades.

Although the monetary policy was empowered in the Monetary Law Act to deal with pandemic-hit supply side of the economy, the central bank did not handle it. Therefore, systemic risks/or structural macroeconomic risks underlying the lapses in the monetary policy in the past decades got burst consequent to pandemic-induced social and economic shocks. The story in nutshell is as follows.

1. Pandemic cause

• The origin of the crisis was the disruption of global supply chains (goods, services and capital) consequent to lockdowns and social distance policies implemented by governments to deal with the global Corona pandemic. The extent of the collapse of supply side of economies and communities across the globe needs no description.

• This led to a historic loss of employment, income, bankruptcies and debt services and thereby the collapse of living standards.

• The resulting civil uprise organized on the political front created tremendous uncertainties in the economy and society and policy reactions that caused unbearable price increases and galloping inflation which is a common feature observed in all countries suffering governance uncertainties.

2. Systemic risks of monetary policy lapses

• The domestic side of the monetary policy was an overnight inter-bank interest rates targeted money printing to assist day-to-day liquidity management of bank money dealers on wholesale basis.

• The external side of the monetary policy was the exchange rate control thorough the foreign currency reserve built on government short and medium term foreign debt. During the last decade, the debt was largely market borrowing where debt services were rollovers. The international sovereign bonds, sale of Rupee securities to foreign investors and foreign currency swaps became a day job of the central bank to top up the foreign reserve. The IMF and World Bank loans also were the top-ups on the foreign reserve from time to time.

• The debt dependent foreign reserve was used to fund the import dependent economy at a subsidized exchange rate administratively fixed by the central bank from time to time. The economy ran a persistent deficit in the BOP current account as the central bank did not implement any credit distribution-based monetary policy to support the real sector to generate a foreign currency surplus and a balanced growth in the real sector. The subsidized debt financing helped keeping the growth as well as domestic prices and inflation at control in eyes of the public. That was the macroeconomic performance story sounded by the authorities to the public.

• Short and medium term interest rates in the banking sector also were controlled through government debt instruments in line with the monetary policy and foreign reserve targets. Therefore, the monetary policy was an accounting exercise inactive on the real side management of the economy.

• The systemic risk underlying this monetary policy stance was the heavy dependence of the economy on foreign currency through short-term government debt.

3. Crisis trigger

• The global pandemic shock which was never a macroeconomic management variable disrupted the foreign reserve. Although the government arranged several foreign credit lines, the top-up was not sufficient to meet debt services, given significant uncertainties running across the economy. Therefore, this is a foreign currency crisis that caused the economic crisis in the country. Such experiences are ample in many countries in the past.

• Although imports and capital outflows were suspended, the monetary policy instruments were not pursued to protect the domestic economy.

• Continuously fixed exchange rate policy, sugar high increase in interest rates and inappropriate announcement of foreign debt default accelerated the inflation, breakdown of markets, economic contraction and BOP deficit into historic levels.

• The inflation constantly claimed by the government as the crisis is in fact an accumulated result of mismanaged monetary policy. The political/social uprise only triggered the onset of inflation. Instead, the crisis is the the mass contraction of the economy caused by the foreign currency crisis and restricted monetary conditions which are the failure of the monetary policy.

• Therefore, this is an economic crisis triggered from the beginning of 2022 fueled by the pandemic in the background of systemic risks of the monetary policy as highlighted above. This is no deferent from crises hit simultaneously in many African countries who followed similar macroeconomic management models except the political/civil crisis in Sri Lanka.

The recovery policy strategy pursued by the government

• It is nothing but the attempt to recover already failed foreign-debt-reserve-based macroeconomic management model highlighted above. The central bank Annual Report 2022 also accepted the model failure behind the economic crisis. The page 1 of the Annual Report states "Having run an unsustainable macroeconomic model in tandem with the longstanding deficits in the budget balance and the external current account, the economy had fully exhausted its buffers by early 2022 as it was straddled by a myriad of vulnerabilities that emanated from both global and domestic sources." 

• The government's focus is the borrowing from the IMF, World Bank and ADB and recommencement of foreign borrowing through the debt restructuring in order to rebuild the foreign reserve and appreciate the currency while bringing back the import market. This is intended to please the general public that the economy is being recovered back despite enormous pains.

• The monetary policy continues to fund the inter-bank market with an abundance of reverse repo lending at frozen policy interest rates and rationed standing facilities.

• The control of both fiscal front and monetary front in line with conditions imposed by the IMF also are intended to rebuild the foreign reserve as believed in the IMF model without any regard to the rock-bottom real economy and structural risks in the country. Such a macroeconomic management policy of fiscal and monetary tightening in a heavily contracted and depressed economy is against all best practices of macroeconomic principles followed in modern monetary economics and Keynesian prescriptions especially after the Great Depression confronted the world in 1930s.

• The default of government domestic debt through forced restructuring of debt to selected lenders under the guise of domestic debt unsustainability and public finance is against modern macroeconomics of fiscal policy. No government in the world has defaulted debt in sovereign currency as the government is the creator of sovereign currency in the country. Therefore, the default of foreign currency debt is a result of unnecessary debt raised in foreign currency, instead of the creation of sovereign currency required for the deficit spending in the interest of the real economy and production capacity. Therefore, the beloved application of household budgeting concept and debt unsustainability to the government budget are against macroeconomic facts.

• Therefore, except for the attempt to recover public finance in the old economics, there is no long-term policy framework presented for the real sector and human development to recover from the present crisis and to forestall the next financial crisis.

Therefore, stories of economic recovery and stabilization articulated by the government are fictitious. This is reflected by the exodus of all ages of labour force looking for foreign opportunities to live.

Funding the recovery and development

The government and all other political leaders expecting the power into the next government make all sorts of promises to develop the country and upgrade living standards. They cite development of various sectors such as agriculture, SMEs, IT and various product lines of their interest.

However, nobody seems to propose how they fund those production lines. Although some talk about foreign investments, they will come to only specific businesses that are globally competitive on low cost if operating/working capital together with fiscal support is ensured locally.

Everybody knows that neither the central bank nor commercial banks are interested in lending to wide-spread business activities such as SMEs and Micro businesses that are instrumental in the growth, employment and income of the economy due to unwarranted business risks.

Therefore, majority economic activities have been depending on expensive informal sector credit leading to uncompetitive cost of production. The export and import trade, wholesale trade, government sponsored entrepreneurs and business corporates are the routine bank customers receiving credit without a hassle. 

1. Non-availability of credit to the broader economy development

All national leaders seem to take it for granted that funding will be available from domestic monetary and banking system when such development works in motion. However, the fact of the matter is that the present central bank does not have any monetary and banking policy to support development-oriented credit distribution. 

• First, its monetary policy is overnight inter-bank interest rates targeted and disconnect from development credit. At present, the central bank is anti-government and anti-money printing in line with tribal monetary concepts behind demand-driven inflation.

• Second, bank credit delivery is highly risk averse and concentrated in profitable business lines. Bank regulatory arm also discourages banking with different risks through requirements of risk-based capital, liquidity, concentrations and provisioning.

• Third, public finance is highly concerned about insufficient tax revenue and borrowing and, therefore, fiscal deficit based development stimulus is off the national agenda of economic development. In general, fiscal deficit is the conduit used in the world over to distribute benefits of sovereign money across the sectors and communities. However, this conduit is no more in the present macroeconomic governance system of Sri Lanka, especially due to legal disconnect between the government and centra bank.

• Fourth, I saw an absurd budget proposal of Rs. 50 bn allocation for SME credit through budgetary spending with the anticipation of it to become Rs. 250 bn through credit creation process (5 times). This is the Treasury getting into the shoes of the central bank. While Rs. 50 bn is peanuts in view of the size and spread of SMEs in the economy, the 5 times creation story has no basis. This shows the lack of practical knowledge in credit and finance among the relevant budgetary officials.

2. Credit in modern monetary economies

Modern monetary economies operate on credit as it is the credit creation that produces and supplies money for the momentum of the market mechanism. Credit is created by the banking system (central bank and commercial banks) and government through book entries and circulates in various financial products across the economy to serve the functions of money. Therefore, financial intermediation for economic development (i.e., mobilization of deposits for lending) is a wrong concept in modern monetary economies.

All developed countries have achieved the present level of real and human development through risk-taking credit created by commercial banks operating in various segments of the economy and society. Before inventing state central banks in the 20th century, free commercial banks were the risk-taking businesses that were instrumental in development of contemporary economies. As a result, financial systems have got deepened to provide financial flows underlying real market flows.

For example, the US financial system has been widening from conventional commercial banking to various types of shadow banking ranging from investment banks, hedge funds, venture capital, exchange traded funds to equity funds. Therefore, the country's financial pyramid is wide enough to support all ranges of risk-takings in real businesses. Commercial banks also operate in several layers such as national banks, regional banks and community banks with the financial support from the Fed to serve financial needs of respective areas/sectors while they are regulated differently to enable them to take sector-specific business risks. The US regulators are still reluctant to impalement Basel III capital standard.

In contrast, EU is mainly a bank credit funded region. Therefore, the European Central Bank implements medium and long-term refinance schemes for priority sector credit distribution.

The fast development of Asian Tigers in 1980s and 1990s was achieved through both directed credit from domestic banks and foreign bank credit free from exchange control. Asian Financial Crisis 1996/97 was a result of currency mismatch behind credit-based funding and resulting foreign currency crisis. However, the crisis was fast resolved through expansionary fiscal and monetary policy mix and non-performing asset management strategies. Therefore, those Asian countries are back on their feet competing with developed countries.

The development story of China is a direct result of credit distribution policy coordinated by the central bank with the government policy.

3. Economic nature of credit markets

Unlike in other markets, credit markets are supply determined where the demand has no role in demining credit prices/interest rates and volumes. This is because credit is created in book entries by banks to take risks they prefer. In that context, the belief that credit creation is a byproduct of deposit mobilization or intermediation is misconceived banking. 

Therefore, credit is always a rationed business by the suppliers and, therefore, interest rates are fixed directly on risks of respective credit categories without any impact or influence from the demand for credit whereas banking business also is rationed by the bank licensing system of the government. In rationed supply, the price has no demand-supply mechanism. Therefore, interest rates based monetary policy serves no purpose in credit creation and distribution in modern monetary economies.

Overall, credit markets are highly risk-based segmented. Therefore, real sector markets also are segmented according to credit segmentation as these markets are driven by credit/money. Accordingly, the disparity in access to credit and credit distribution is a major cause for economic disparity among sectors and households. Therefore, this disparity can largely be reduced through regulation to provide for fair access to credit among economic sectors and households where banking that creates credit is itself a publicly regulated and licensed business.

4. Global experience in credit regulated for development objectives

The development story of almost all countries up to 1980s is connected with the credit policies of the government implemented through central banks to distribute credit across the sectors and activities. Therefore, credit delivery is the single most factor instrumental in economic development and upliftment of living standards in the present world. 

In this regard, directed credit, refinance, credit insurance and credit guidance played a national role in fair distribution of credit in the wider economy. It was the state intervention carried out to reduce credit market segmentation in the interest of national economic development. The fiscal policy also played a supportive role. The control of sovereign currency through public finance was a plus point in credit distribution regulation.

Sri Lanka also pursued this sort of monetary policy model in 1980s -1990s. However, since early 2000s, the central bank moved to overnight inter-bank market liquidity-based present monetary policy model by letting bank credit risk models to serve credit needs of the rest of the economy. This is the main factor responsible for the macroeconomic structural imbalances and risks that triggered the present foreign currency-induced economic crisis.

Public concerns and recommendations

• In view of above facts presented, national leaders who propose national recovery and prosperity models should also present a credit distribution model to fund the respective economic models because they do not bring necessary funding from their homes. In this regard, specific credit schemes should be liberal adequately to encourage mobilization of productive resources through markets as bureaucrats who perform day jobs are unable to decide on identification of resources and mobilization required for national recovery. Otherwise, the proposed economic recovery models will only be an useless lip service.

• However, the present models of monetary policy and fiscal policy implemented under the IMF macroeconomic governance and surveillance will be the major hurdle in drafting and implementing the proposed credit distribution model.

• Even if the government wishes to implement such a credit distribution model as proposed, the central bank and monetary policy which should implement it are prevented by the new central bank legislation because legal provisions that were in the Monetary Law Act have now been rescinded in the new legislation.

• Therefore, any government that stands to implement a recovery friendly credit distribution policy will need to pass a separate legislation requiring the central bank and banks to do it. For example, the US government passed the CARES Act in June 2020 in the wake of the Corona pandemic to provide direct economic aid of about US$ 2.2 trillion to the economy where the Fed was required to implement special lending schemes for private businesses affected by the pandemic in addition to its normal sector-based lending powers. As a result, the Fed's money printing rose historically by 110%. When financial media questioned the Fed Governor about possible inflation, he responded that the Fed would deal with the present human crisis now without paying attention to inflation hypothesis and look at inflation control later if necessary. The Fed is still in tact of those credit schemes as the recovery of supply chains still lags. In contrast, the central bank in Sri Lanka resisted such lending and, in fact, it tended to absorb liquidity from the banking system in the wake of the pandemic. If the central bank injected a new credit flow of at least around Rs. 2,500 bn for the private sector for production activities, the contraction impact of the foreign currency crisis could have been forestalled and the country by now could stand at own feet without begging from international community.

• The grave danger in the proposed credit legislation is the risk of overthrowing the government by the central bank through a new round of political allegation over inflation ghost. The central bank will consolidate opposition political leaders and international economist to allege the government that such credit expansion will create inflation. However, this allegation would be baseless due to favourable supply side effects of productive credit distribution.

• Further, the new central bank legislation poses several systemic risks to the monetary system and economy in many areas. A few major ones are as follows. In this context, the country does not have a monetary system that can support a credit distribution model as proposed.

• Restrictions on central bank credit to the government including indirect credit. This will restrict open market operations and the supply of reserves to meet the demands of the economy. Central bank reserves is always indigenous money.
• Permission for central bank credit to shadow banks exposing the monetary system to shadow bank risks. Instead, shadow banks are intended to support innovations and business risks in the broader pyramid of markets.
• Removal of conventional lender of last resort facility from the central bank making the liquidity injection in times of banking and financial crises a responsibility of the fiscal policy. The allocation of Rs. 450 bn budgetary provision in 2024 budget to support the capital improvement in the banking sector is an early fiscal measure in this regard. It is strange that the central bank has failed to ensure capital adequacy requirements through shareholders of banks who earn a secured profit through credit creation in bank book entries. Therefore, the rationale for using tax money to bailout shareholders of banks who take credit risks of wealthy segments of the society is questionable.
• Removal of standard official unit of monetary value in Sri Lankan economy paving the legal ground for private monetary units and currencies competing with sovereign/legal tender currency notes and coins in the future. In the new monetary legislation, the country has only legal tender/currency as a medium of exchange but it does not have an official unit of monetary value. Therefore, private parties an use own monetary units for contracts and transactions with the parties accepting it.

I hope that fact-based views expressed independent of any political biases as above would help national leaders to make fruitful efforts for the national economic and human recovery in terms of modern monetary and supply side economic principles.

However, this is impossible without fearlessly abandoning tribal economic concepts surrounding inflation used presently by monetary and fiscal policy officials for their day jobs.

If national leaders plan to recover the economy and living standards by clicking with those concepts and officials as divine-prescribes, they can expect only the God's bless for their long-term survival.

(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)