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Serving Sri Lanka

This web log is a news and views blog. The primary aim is to provide an avenue for the expression and collection of ideas on sustainable, fair, and just, grassroot level development. Some of the topics that the blog will specifically address are: poverty reduction, rural development, educational issues, social empowerment, post-Tsunami relief and reconstruction, livelihood development, environmental conservation and bio-diversity. 

Tuesday, April 26, 2005

Central Bank sounds alarm but will government open its eyes?

The Sunday Island: "24/04/2005 By R.M.B. Senanayake

The Deputy Governor appeared on television the day before the New Year and explained why the Central Bank alone cannot control inflation. For the first time in fifty years the Central Bank avoided Orwellian double speak. He explained why the oil and electricity subsidies must be removed and their retail prices revised upwards. Although that will raise the prices of goods all round since transport is a cost component of most goods & services including bus & train fares, he pointed out that it would be a one-off price increase.

Economists generally define inflation as a continuous increase in prices. If the subsidies on oil and electricity are funded by bank credit with cannot be repaid, the end result boils down to a license to print money. This would mean more and more money chasing a supply of after goods whose production cannot increase in the short-run (except through imports) and thus cause galloping inflation. The Minister of Finance in his budget speech referred to the provision of subsidy on petroleum but did he provide money for it in his budget? If so why doesn’t the Treasury re-imburse the cost of the subsidy to the Petroleum Corporation. If it wants to go back on the budget pledge, it must revert to the pricing formula of the UNF government which decreed that the selling price will reflect the procurement price. This was adhered to until the election and then abandoned.

Electricity crisis

Electricity is a more serious problem. The CEB cannot afford to pay the high prices for the emergency thermal power from the private sector. If they cut-off their supply there will have to be power cuts. So there is no reason to subsidise electricity. In the long run coal power has to be harnessed but in the short run the public will have to grin and bear the actual cost of electricity which includes the cost of the bloated staff of the CEB and the 20% wastage of electricity due to illicit tapping and technical losses in transmission. It’s time the lotus-eaters woke up. There is a cost to the postponement of economic decisions and we have to pay for the delay in Norochcholai coal power project and Upper Kotmale.

The actual cost of power will render most heavy industries uneconomic and several steel fabricating mills have already closed down. We go round the world and sign free trade agreements but we fail to realize that the opportunities opened up will not be utilized unless we make our economy globally competitive.

Ineffective Central Bank

Dr. Nadeem Ul Haque the former resident Representative of the IMF used to discuss the abysmal economic illiteracy of the country with the late Dr Lal Jaywardene. He once gave a lecture which he titled "De-mystifying Central banking". He pointed out that when the Federal Reserve System (the US Central Bank) was set up, Treasury officials were debarred from membership of the bank. He also pointed out that in Germany & Japan after the First World War, their Central Banks used the need to rebuild their war-damaged economies as an excuse to print excessive quantities of money. This led to the hyperinflation in Germany, which crippled the German middle class and ultimately brought Hitler to power. So after the Second World War the concept of an independent Central Bank came into vogue.

Germany learnt its lesson and the Reich bank fiercely upheld its independence. Ranil Wickremasinghe amended the Monetary Law Act to provide for greater independence for the Central Bank. But in our country which is woefully short on independent minded people, the law is not enough to ensure independence of institutions like the Central Bank.

During the colonial period we managed well without a Central Bank. The money supply was tied to the external assets – the Sterling balances held by the banking system. The money supply could expand only if there was a balance-of-payments surplus, which led to the increase of foreign reserves. The government could not borrow from the banking system without repaying - printing money in popular economic parlance. There was no lender of last resort. Instead of a Central Bank there was only a Currency Board, which was in charge of the note issue. We did not have inflation.

When we received independence our leaders thought a Central Bank was a mark of sovereignty. So one was set up in 1950.Of course the bank was set up on the advice of foreign economists. But as Dean & Pringle (quoted by Dr. Nadeem Ul Haque) points out they were "breathtakingly na`EFve". Soon we had a populist government in the form of the SLFP in 1960 when T. B. Ilangaratne introduced deficit budgeting, which soon became our budget culture. The power of printing money or borrowing from the banking system is like giving a razor to a monkey. The politicians thought it was magic. Politicians love to spend money since it builds their popularity and influence. Normally if an individual wants to spend more he must earn more for borrowing is only a temporary resort. But a government with a Central Bank can live perpetually on tick and print money to fund all the goodies it wants the people to enjoy and vote for them.

So the Bank of Ceylon was nationalized and the Co-operative Federal Bank, which was financing the co-operative societies, was taken over by the government and called the People’s Bank. Both banks were now used by the ministers to give massive loans to crony businessmen who lacked adequate collateral. The result is that these banks were saddled with bad loans and the people had to bail them out twice.

Taxing the people through inflation

The governments also introduced capital controls to isolate the domestic economy from international capital movements. This made it possible for the Central Bank to depress domestic interest rates and allow the perpetually hard-up Treasury to borrow cheap. High reserve requirements were clamped on the banks to tax bank deposits and deprive the savers of positive real interest rates (nominal interest rate less inflation rate). All these measures allowed the government to impose what economists call the tax’. Through inflation, which reduces the purchasing power of the people but not of the government, (which resorts to printing money) goods & services are transferred from the public to the government. The reduction in the purchasing power of the people is matched by an increase in the purchasing power of the government. So the President pretends even God Sakra can’t control inflation. Why should the government want to control inflation? If it can pretend it has nothing to do with the inflation and that it cannot be controlled by anybody - by blaming it on the world market or the devil it would have pulled off the rope trick.

The Monetary Board sings for its supper

The Monetary Board has refused to raise the interest rate although savers are getting negative real rates of interest. The Central Bank has in the last one year increased its holdings of Treasury Bills by Rs. 50 billion. Now they say the bank will mop up the excess liquidity through open-market operations which refer to the bank selling the Treasury bills & bonds it holds and extinguishing the money received as payment for them. But who are the buyers of these Treasury securities? The commercial banks have shown an unlimited appetite for government securities since they are risk less and are an easy means of profit. They can hold any amount of such securities in their investment portfolio. So when the Central Bank sells Treasury securities the commercial banks may well buy them knowing that if they run short of liquid reserves (they have to keep a minimum cash reserve of 10% with the Central Bank) they can always discount them cheaply through the Central Bank’s re-purchase and reverse-repurchase window.

If the Central Bank doesn’t wish to raise its policy interest rates it must fix ceilings for the holdings of government securities by the banks. The bank must similarly limit the lending to the loss-making state corporations like the CEB and the CPC since they are using the credit not for working capital but to give subsidies to the people by way of running continuous losses. It could also raise the statutory liquid ratio since the benefit of a low ratio is helping the government and not the private sector.

Why have a Central Bank at all?

Eminent economists like Hayek and Friedman have argued against having a Central Bank and advocated free banking instead. Friedman also questioned the desirability of discretionary monetary policy. He advocates a rule for the rate of growth of money. (Vide Dr Nadeem Ul Haque.) The Central bank has fixed a limit of Rs. 15 billion for the Reserve Money for this year, which is already exceeded.

The money supply growth target of 15% is now exceeded, being over 19. %. The CEB & the CPC are creating Rs. 2.5 billion of new money each month. They will soon bust the economy just as the President did in 2000 when the government borrowed Rs. 50 billion from the Central Bank and another Rs. 40 billion from the commercial banks. The economy collapsed into negative figures for the first time since Independence. Expect a repeat performance this year too. The Central Bank has now sounded the alarm and it is up to the government to stop funding the public sector expenditure by printing money if it wants to avoid inflation.

The Central bank must explain how it hopes to bring down the rate of inflation or whether it will act like the lamb that followed Mary. It is pretending that inflation is due to supply factors and that everything will be tickety- boo with the better paddy harvest.

Blogger power100 said...

You are so right.
last year inflation went up to 16.8%, all because government printed 65 billion rupees.
it is sad that sri lankan's don't realize this.
the government is saying oil prices drove prices up. but they did not raise oil prices in 2004 - or if they did only a little in september.
then how did prices suddenly skyrocket?
it is a sad situation. problem is treasury has basically made monkeys out of the monetary board.
ordinary people do not know why inflation is going up in sri lanka.
2004 was perhaps the record for incompetent fiscal management in sri lanka, which was coupled by loose monetary policy  

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