Governor of the Central Bank Ajith Nivard Cabraal
The Central Bank of Sri Lanka (CBSL) has come under heavy criticism over the currency’s rapid expansion supply since last year. The overall money supply has grown by 21% in the past 12 months. The currency held by the public, commonly known as money printing, increased by about 23% during this period. This is due to continued government borrowing from CBSL and commercial banks.
This trend would continue in the coming months unless the government reduces its dependence on the banking sector to finance the budget deficit. Such a possibility is rather remote, as there are hardly any other sources of funding. In addition, CBSL is unlikely to reduce budget accommodations amid political pressure.
CBSL governor’s point of view on money supply and inflation is unacceptable
Newly appointed CBSL Governor Ajith Nivard Cabraal says printing money has no impact on inflation, as ‘Divaina’ newspaper reported last Sunday. He further stated that the excess money issued can be absorbed by CBSL whenever the need arises. This view involves at least two basic caveats.
First, the claim that there is no relationship between money printing and inflation violates basic economic principles. Irving Fisher (1867-1947) formalized the relationship between the two variables in terms of his “Theory of the Quantity of Money”, which was later developed under the name Monetarism by Milton Friedman (1912-2006). Based on rigorous quantitative studies across the world, the two-way relationship between money supply and inflation is undeniable.
Second, the CBSL is unable to absorb excess liquidity whenever it is needed, as the Governor claims. This is because CBSL continues to buy the unsold portion of treasury bills and bonds directly from primary auctions to fill government coffers, instead of selling these securities through open market operations. to mop up excess cash.
Rise in CBSL’s holdings of government securities
CBSL’s continued loans to the government resulted in a substantial increase in its holdings of treasury bills and bonds. These holdings have increased by 52% from Rs. 874 billion to Rs. 1,330 billion in the past 3 months (Chart 1).
As a result, the CBSL had to abandon one of its main monetary policy instruments, namely open market operations (OMO). The CBSL can generally adopt the OMO to mop up any excess liquidity in the market by selling its government securities, and vice versa. Market demand for these securities is lower due to their low rates of return and therefore CBSL is not able to sell them for restrictive monetary policy purposes, even if it wishes, as mentioned above. -above.
There are constraints on foreign borrowing, as evidenced by the heavy subscriptions of international sovereign bonds during recent auctions. Even local auctions of treasury bills and bonds were heavily underwritten because of their unattractive yields. For example, the treasury bill auction held last week was 50% underwritten. The rest of the treasury bills had to be purchased by CBSL to meet budgetary needs, which resulted in an increase in its holdings of government securities and foreign exchange issues. This has been the practice in recent months.
Is money printing the right treatment for the struggling economy?
Governor Cabraal, in his capacity as Minister of State, strongly advocated the printing of tickets for the recovery of the economy affected by the pandemic. In an interview with the Daily Mirror last month, he mentioned that printing money is like drastic treatment prescribed by a doctor for serious illness (https://www.dailymirror.lk/hard-talk/Money -printing-is- as-a-drastic-treatment-of-a-major-disease-Ajith-Nivard-Cabraal / 334-217302).
He added that money printing only leads to inflation in normal times. As there is a contraction in the economy at present, the risk of inflation occurring as a result of printing money is much less. Once the economy has returned to normal, it must be withdrawn, he said.
He also reiterated in several forums that the government can solve the debt problem without resorting to the IMF.
It should be noted here that the printing of money was not due to the pandemic but was the result of the Government borrowing from the banking sector to finance the budget deficit. The excessive monetary growth resulting from the increase in bank loans to the government has led to demand pressures on the domestic market and imports, thus causing inflation, the imbalance of foreign trade and the deterioration of the rupee, all quite contrary to Cabraal’s assertions. Annual inflation, measured by the Colombo Consumer Price Index (ICPC) has reached 6% to date, as shown in Figure 2.
It is impossible to contract the money supply in the current inflationary situation, as Cabraal argues since the banking sector will have to continue lending to the government to fill its revenue gaps, caused by the drastic tax cuts implemented last year. .
Contrary to Cabraal’s plea, printing money is bad treatment for the struggling economy that could even lead to the killing of the patient, as I pointed out in this column last month (https: // www. ft.lk/opinion/Rupee-under- stress-as-trade-deficit-expands / 14-721803). Money creation will only worsen the economic evil by widening the trade deficit and accelerating inflation.
CBSL lost its market-based monetary tools
The CBSL reformulated its monetary policy in the 1980s and 1990s from direct controls to market-based tools to align with the liberalized economic environment. It has gradually phased out credit checks and comprehensive credit limits. Eventually, open market operations and key interest rates as well as a flexible exchange rate system became the main tools of monetary policy.
Recently introduced direct monetary controls, including interest rate caps, credit caps, exchange rate fixing and exchange regulations reflect a reversal of market-based monetary policy. They have negative effects on free market activity, as already evidenced by inflationary pressures, commodity shortages, underwritten government securities, currency depletion and exchange rate distortions.
Abandonment of inflation targeting on monetary policy
The previous government planned to implement a flexible monetary policy framework targeting inflation by 2020 under the Fund’s Extended Facility (EFF) with the International Monetary Fund (IMF). To this end, the now abandoned Central Bank Bill had to be approved by Parliament to replace the current Monetary Law Act.
Inflation targeting is a monetary policy strategy whereby a country’s central bank aims to maintain a pre-announced rate of inflation over a period of time. Transparency and accountability are two essential elements of inflation targeting. Transparency implies that the central bank communicates the inflation target with justification through public announcements. Responsibility means that the central bank must not miss the inflation target.
Monetary policy targeting inflation would have given CBSL greater independence, shielding itself from political pressure to conduct monetary policy targeting its primary objective of price stability. These initiatives have been abolished by the current regime. As a result, the Governor of the CBSL continues to afford the luxury of implementing harmful monetary policy measures without any transparency or accountability.
A vital independent central bank
The political space available to the CBSL to conduct independent monetary policy is severely constrained by fiscal dominance, as I explained in last week’s FT column (https://www.ft.lk/opinion/Distancing -the-Central-Bank-from -politique-vital-pour-la-stability-économique / 14-723012).
The budget deficit which currently exceeds 12% of GDP will remain high with growing debt commitments in the years to come. The persistent budget deficit discourages CBSL from adopting a flexible interest rate policy, while inflationary pressures and growing external debt commitments limit its ability to maintain exchange rate flexibility. Indeed, monetary policy is now inactive.
Under these circumstances, the current monetary expansion as well as direct credit and foreign exchange controls will continue to prevail over the coming months, leading to adverse effects on prices and financial stability, as tensions in the markets are already showing.
The ability of the CBSL to reactivate a market-based monetary policy for the purpose of economic stabilization depends on its ability to diffuse the political pressures that lead to monetary expansion. This would be an impossible task as long as the leadership of the CBSL is subject to the political masters.
(The author is Emeritus Professor of Economics at the Open University of Sri Lanka and former Director of Statistics at the Central Bank of Sri Lanka, contactable at [email protected])