This article sheds some light on monetary policies communicated by the Monetary Board (MB) since January 2016.
Monetary Policy neutrality
The policy neutrality claimed by the MB last month is the simultaneous policy action on two policy instruments in opposite directions.
One was to reduce statutory reserve requirement (SRR) by 1.5% to 6% (policy relaxation) and the other was to increase policy rates, i.e., Standing Deposit Facility Rate (SDFR) by 75 basis points (bps) to 8.00% and Standing Lending Facility Rate (SLFR) by 50 bps to 9.00% (policy tightening).
This neutrality is a wrong ideology as the effects of the two policy actions on the economy are not known to be equal. First, the injection of liquidity of around Rs. 90 bn due to reduction of the SRR and unknown reduction in the demand for liquidity due to the increase in policy rates by 50-75 bps cannot be stated as equal.
Second, the lagged effects of additional credit created by the reduction in SRR and deceleration in credit expected due to the increased policy interest rates are not known. Therefore, the stated policy neutrality is bad economics and math for the MB.
There are some concepts of monetary policy neutrality. The conventional one is the neutrality of money or money supply on the real economy (output and employment) in the long-run at the full employment where any change in the quantity of money or monetary policy would cause only proportionate changes in inflation/general prices. Second is the neutral interest rate currently pursued by the US Fed. Third is keeping the monetary policy unchanged.
Therefore, the MB has used the neutrality term to cover up the policy rates hike effected last month.
Monetary Policy tightening
In October, the MB declared that the monetary policy was tight in real terms although the MB does not have any targets on real interest rates. The policy of keeping policy interest rates unchanged was to support the domestic economy in view of depressed growth than expected and low inflation well below the MB’s target of 4-6% in the undefined medium-term.
Last month, the MB declared that the tight monetary policy followed in the past was reflected in subdued core inflation.
In view of the low growth and low inflation, the monetary policy stance now needed is a relaxed monetary policy. The growth of money supply also has been decelerating since March 2018 well below the 15% reporting threshold prescribed in the Monetary Law Act (MLA). Although the MB talks about “some growth of credit to private sector”, the monetary conditions including inter-bank liquidity remain tight reflecting the tight monetary policy adopted since January 2016. However, the present monetary policy tightening is to prevent capital outflow and currency depreciation which would be inflationary in the future, given the country’s high exposure to foreign currency.
Reduction in Policy Rates corridor
In April 2018, the MB cut the SLFR by 25 bps. This reduced the policy rates corridor (gap between the SLFR and SDFR) to 1.25%. The MB states that new policy rates in November would reduce the corridor to 1% which would lower the bank interest margin (margin between lending rates and deposit rates).
However, interest margin is the intermediation cost determined by the cost and risk structure of banks. The policy rates corridor is only a policy of the MB on permitted volatility of the overnight inter-bank interest rates.
The corridor of the US Fed is 25 bps. The Bank of England has only one policy rate which means no corridor. Some Central Banks use several policy rates.
Money printing
In Sri Lanka’s banking sector, interest margin (% of average assets) has risen to around 4.5% towards 2010 and declined to 3.5% towards 2017. This has nothing to do with irregular/few instances of changes in the policy rates corridor.
Therefore, the MB needs to be careful when interpreting its monetary policy instruments without the support of economic research under Section 25 of the MLA.
In October, the MB stated thattight market liquidity resulted in an increase in market interest rates. However, the MB did not raise interest rates but heavily injected liquidity to the inter-bank market.
Therefore, total injection of overnight liquidity since beginning of September 2018 was Rs. 913 bn up to November 2, 2018 and Rs. 2.7 trillion up to December 12, 2018.
Although the MB in its press release on November 7, 2018 denied reckless money printing as on November 2, 2018, such extent of liquidity injection in fact is reckless money printing as it was caused by the policy lapses and deaf-delay.
Although gross book value of CB’s government securities holding was Rs. 67.4 bn as at November 2, total holding used by the CB to fund the government and inject liquidity to the market was Rs. 224.3 bn. Money printing through interest-free intra-day liquidity facility and provisional advances to the government also has to be added.
The same press release confused the public by stating a net book value of Treasury Bills holding (Rs. 224.3 bn) and a gross value of government securities holding (Rs. 67.4 bn) on November 2.
The fact of the matter is that the outstanding liquidity pumped/printed by the CB to the inter-bank market alone was Rs. 156.9 bn. The printing was Rs. 224.3 bn including the Treasury Bills purchased by the CB to fund the government as at that date.
With all due respect to the technicality of the article stated by the CB in the same press release, the drastic volatility in the amount of new money printed and its principal sources during the period of 2013-2017 (between Rs. 4.2 bn to Rs. 182.7 bn) reported in the article reflects the reckless money printing.
The stability in money printing is helpful for the economy and financial system to be stable.
Monetary Policy tightening phase
The MB started tightening the monetary policy suddenly at the end of December 2015 and reversed the trend of falling market interest rates that prevailed since mid-April 2015 as follows:
First, in January 2016, the MB suddenly increased the SRR by 1.5% to 7.5% to remove the excess liquidity immediately to address concerns over high credit growth and rising BOP trade deficit.
Nearly Rs. 52 bn of bank liquidity was absorbed and the interbank market became huge ill-liquid as the policy was implemented without pre or post impact assessment.
Money market/Treasury Bills yield rates immediately rose by 50-75 bps and the CB started injecting liquidity to banks to keep inter-bank interest rates within the policy interest rates corridor.
Second, in February 2016, the MB, without waiting for the transmission effect of the reduction of the SRR, raised policy rates by 50 bps and communicated further rate hikes if necessary, despite a huge funding requirement of around Rs. 125 bn pending for the government on April 1, 2016. Therefore, all markets were disrupted.
Third, in July 2016, policy rates were again raised by 50 bps with comments that commercial/market interest rates had increased. The reason being the fast monetary tightening since January 2016, was never mentioned.
Fourth, in March 2017, the MB raised policy rates by another 25 bps to 7.25% and 8.75%.
Fifth, in November 2018, the MB raised interest rates further to 8% (by 75 bps) and 9% (by 50 bps) and cut the SRR back to 6%.
Sixth, in December 2018, the MB kept interest rates unchanged although the policy in November could not address liquidity shortages and excessive currency depreciation.
In July 2017, the MB reintroduced direct placements to bond issuance system as an instrument to control market interest rates within the monetary policy although it is only a debt issuance instrument.
However, the MB has not been able to stabilise interest rates or yield rates (see Chart). The MB has increased the CB’s holdings of Treasury Bills to Rs. 230 bn as on December 12, 2018 to reduce pressure on interest rates.
The economy has got into economic downturn although the MB is complacent about low inflation measured by subsidy-driven cost of living indices.
MB’s recommendation
The MB continues to blame the government for the MB’s failure to stabilise the economy. The press release in November states, “In order to accelerate growth on a sustainable basis, it is essential that growth enhancing structural reforms are carried out within a coherent and transparent framework, rather than relying on unsustainable short term monetary and fiscal stimulus, which leads to overheating of the economy.”
In December also, the MB outlined the need to implement broad based structural reforms without further delay.
There is nothing wrong if short-term monetary and fiscal stimulus can overheat the economy at this sluggish stage. The MB does not reveal the growth enhancing structural reforms and coherent and transparent framework. However, the MB is also responsible for the stability of the economy with wide monetary, exchange and financial regulatory policies.
Risk of stagflation
Monetary policy is in the extended tightening cycle that commenced in January 2016. As the increase in SRR by 1.5% is now taken off, the monetary policy tightening so far in terms of policy interest rates is 2.00%.
The growth of money supply (M2b) has declined from 17.8% in December 2015 to 13.9% in November 2018 whereas growth of bank credit correspondingly decelerated at a faster rate from 26% to below 10% up to June 2018 and to 16% in November 2018.
The sluggish economy since 2016 is reflective of tight monetary policy, among other factors. The US Fed on December 19 communicated two further rate hikes in 2019.
The European Central Bank also communicated the commencement of policy tightening in 2019. Therefore, the MB has not practical space to relax monetary policy to support the economy. It is highly probable that the economy will suffer stagflation conditions in years to come.
National credit-based Monetary Policy
The MB’s policy irrationality is proved by many contradictions of policy actions and communications. The MB’s non-compliance with the public mandate as set out in the MLA and the Exter Report is clear.
The present policy rates corridor-based OMO/money printing which was actively commenced in early 2000s is not the national monetary policy mandated in the MLA. Instead, this policy facilitates bank dealers to make speculative profit on CB’s liquidity.The policy mainly depends on the inter-bank interest rate target which is mostly suited for countries with active credit and capital markets. In Sri Lanka, bank credit/intermediation is the dominant source of finance for the economy.
Therefore, almost all economic sectors lack credit at affordable terms to promote the domestic economy. Foreign investments can be attracted only with a promising outlook of the domestic economy.
Therefore, the MB has to adopt a wider monetary policy framework based on sectoral credit distribution at differentiated terms favourable for the growth of domestic economy as stipulated in the MLA.
The young economists in the CB who plan to live in the country need to do economic research in the country and innovate the policy framework to suit the Sri Lankan economy.
This is not a rocket-science, but to act under the principles and provisions of the MLA to promote credit to facilitate mobilisation of productive resources at affordable costs. If the MB is not willing, the government has the mandate to direct the MB to adopt the government’s policy. -
The writer is a former Deputy Governor of the Central Bank