The current government has decided to drop the CBSL bill alongside its recent decision to postpone the fiscal policy targets stipulated in the Budget Management (Accountability) Act of 2003 until 2030. These two fiscal policy decisions and monetary policies are likely to have serious repercussions on the country’s already poor macroeconomic stability
A few days ago, the government repealed the Central Bank of Sri Lanka (CBSL) Bill, which sought to repeal the 70-year-old Monetary Law Act with a view to transforming the CBSL into a more monetary authority. independent, while putting in place measures to improve transparency and accountability.
Strengthening the institutional framework of the CBSL through this bill, as well as tax reforms, was a key element of the structural adjustment program envisaged by the previous government under the Extended Fund Facility (EFF ) concluded with the International Monetary Fund (IMF) for the three-year period, 2016-2019.
The current government has decided to drop the CBSL bill in conjunction with its recent decision to postpone the fiscal policy targets stipulated in the Budget Management (Accountability) Act of 2003 until 2030, as I explained. in last week’s column (https: // www.ft.lk/columns/Fiscal-policy-corrections-postponed-until-2030-defying-IMF-support/4-719478).
These two decisions relating to fiscal and monetary policies risk having serious repercussions on the macroeconomic stability of the country, which is already in bad shape.
CBSL reform roadmap abandoned
With the maintenance of macroeconomic stability, especially price stability, being the key role of CBSL, the bill recognized the Central Bank as an autonomous body and provided legislative powers to protect itself from any influence or interference. .
Under the new bill, the current monetary targeting framework was to be replaced by an inflation targeting monetary policy framework in order to prohibit excessive growth in the money supply resulting from government borrowing.
The CBSL adopted a comprehensive roadmap in 2017 providing for the enactment of the CBSL bill in 2019 and the implementation of the inflation targeting monetary policy framework in 2020. This roadmap is now abandoned.
Former CBSL Governor Dr Indrajit Coomaraswamy, with the assistance of then Deputy Governor Dr Nandalal Weerasinghe, played a central role in pursuing innovative reforms.
Central bank independence is crucial for economic stability
Central bank independence is about freeing the monetary authority from the direct influence of the government to allow it to focus on prices and economic stability, rather than adopting populist policies to keep voters happy. whims and fancies of the ruling political party.
It is widely recognized that a sufficiently high level of central bank independence is desirable to achieve the main objectives of the central bank, namely price stability and financial stability.
One might ask why the central bank should be independent? Why can’t it function like any other department? The answer is that independence is essential to protect the central bank from the government’s anti-inflationary biases. Politicians generally prefer to boost production, employment and short-term social welfare with the aim of winning elections.
The result is an increase in public expenditure and a widening of the budget deficit in the absence of a concomitant increase in tax revenue. In order to easily finance the budget deficit, the government can use the power of the central bank to print fiat money that does not require any guaranteed reserves.
CBSL’s autonomy recognized in the new bill
This LBA does not contain any clause relating to the independence of CBSL.
In contrast, article 5 of the new bill recognizes the CBSL as an autonomous body. It states: “The autonomy of the Central Bank shall be respected at all times and no person or entity shall exert any influence on the members of the Governing Board, the Monetary Board and the Board of Directors or on its employees in the exercise, exercise and exercise of their powers. , functions and duties under this Act or interfere with the activities of the Central Bank.
Proposed changes in the governance structure
In order to give more independence to the CBSL, the new bill proposed to introduce three councils instead of the single monetary council currently in force under the LBA. They are (a) the Governing Board responsible for the administration and management of the CBSL, (b) The Monetary Policy Board, which is responsible for formulating monetary policy and implementing a flexible exchange rate system in accordance with the flexible inflation targeting framework, and (c) the Board of Directors will be responsible for the day-to-day operations of CBSL.
The new bill limited the president’s exclusive power to appoint the governor of CBSL. Consequently, the president, with the consent of the Constitutional Council, appoints the governor and the members of the board of directors and the experts of the board of monetary policy.
Printing money under MLA for deficit financing
Under this LBA, CBSL may extend credit to the government by (a) purchasing treasury bills in the primary market, (b) purchasing treasury bills, and (c) making interim advances to the treasury. These loans end up constituting CBSL’s net credit to government (NCG) as an asset on its balance sheet.
NCGs and net foreign assets (NFAs) held by CBSL form the monetary base or major currency, which is reflected in the form of banknotes and coins or currencies on the liabilities side of CBSL’s balance sheet.
Money base has multiplier effects on the overall money supply, as commercial banks can use it as the basis for credit creation. The increase in central bank lending to the government in this way has had a considerable positive impact on the monetary base since last year. The impact on the monetary base, and consequently on the aggregate money supply, was partly offset by a fall in NEA due to the balance of payments difficulties encountered in recent months.
CBSL’s net credit to government rose 74.1% to Rs. 1.055 billion at the end of last month from Rs. 606 billion a year ago. This reflects the extent to which the CBSL has been put under pressure by the government to meet its cash requirements, in the absence of central bank independence.
Time inconsistency problem
The monetary expansion generated by such deficit financing could help revive short-term economic activities, satisfying the government, but it fuels inflation causing macroeconomic instability. This would force the government to reverse its policy after a while. Economists qualify this notion of “temporal inconsistency”.
It is argued that the problem of time inconsistency can be overcome by delegating monetary policy to an autonomous and conservative central bank. The term “conservative” means that the central bank is more averse to inflation than the government. If the central bank follows the same policies as the government, the question of autonomy does not arise. The need to have autonomy for the central bank implies that the political authorities are not credible. Empirically, we find that countries with independent central banks experience lower inflation, compared to countries with central banks controlled by the government.
Inflation targeting monetary policy
Perhaps the most important reform envisioned in the CBSL bill was to institutionalize inflation targeting as the basis of monetary policy formulation, which was to be fully implemented in 2020.
The inflation-targeting monetary policy framework that targets a specific medium-term inflation rate has been increasingly used by several central banks around the world in recent years. Central banks react to any deviation from target inflation through their key interest rates.
In order to insulate monetary policy formulation from fiscal pressures, the bill explicitly prohibits CBSL from extending credit to the government or any government-owned organization other than public banks. The bill also prohibits CBSL from purchasing government securities (i.e. treasury bills) in the primary market.
In addition, the bill limits provisional advances to 10% of public revenue for the first four months of the previous fiscal year, unlike the LBA which allows 10% of estimated public revenue for the year as a whole.
Under the bill, the Minister of Finance and CBSL are required to sign a monetary policy framework agreement on setting the inflation target to be achieved by CBSL. The Minister must publish the framework for monetary policy, including the inflation target and other related parameters, by means of a notification in the Official Gazette within one week from the date of the agreement.
The inflation target and other related parameters should be reviewed once every three years or at other intervals in exceptional circumstances. If the CBSL fails to meet the inflation target within the specified range, the Monetary Policy Board was required to submit a report to Parliament through the Minister detailing the reasons for the failure and the corrective measures to be taken. take within a specified time.
Cautious fiscal and monetary rules abandoned
The misalignment of budgetary and monetary policies is at the origin of the current macroeconomic imbalances which force the CBSL to fix simultaneously the interest rates and the exchange rate, going against the dominant economic principles in recent months, as recalled. this chronicle.
The budget deficit rose to 11.1% of GDP last year, and it is going to be even higher this year, given the revenue shortfalls and spending overruns. The accommodation of budgetary needs by the CBSL has led to an increase in the money supply by 21% over the past 12 months, threatening price stability.
The increase in liquidity has put pressure on import demand, worsening the balance of the situation which is already affected by the increase in external debt service commitments. Amid the currency shortage in the banking system right now, the rupee is expected to depreciate further against the US dollar and other major currencies, leading to further increases in consumer prices.
These macroeconomic imbalances could have been avoided, at least to some extent, if the fiscal targets set out in the Fiscal Responsibility (Management) Act (FRMA) and the inflation-targeting monetary policy framework in the bill. on CBSL had been implemented. Now, the FRMA’s budgetary targets are postponed to 2030 and the CBSL bill is completely abandoned, leaving no hope for economic stability.
Therefore, severe economic hardship, including the economic downturn, consumer price hikes and shortages of essential consumer goods, is unlikely to disappear in the foreseeable future, causing enormous hardship for human beings. the street.
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]