By a former Central Banker
An article written by Dr Kenneth De Zilwa titled “CBSL finally cut its key policy rates reversing the austerity mindset - Was SL forced into a ‘Balance sheet recession’?” appeared in the “The Sunday Morning” on May 24, 2020. As an “Economist”, “business cycle analyst” and a member of the “monetary policy consultative committee”, De Zilva’s implied alternative approach to monetary policy formulation in Sri Lanka deserves to be analysed. Although he has quoted an impressive array of economists from different “schools’ in support of his proposition, there are unfortunately some factual inaccuracies in his article which appears to give a political slant and distort his arguments that is dealt with in this response.
[caption id="attachment_60803" align="alignleft" width="300"]
It is doubtful that too many Sri Lankans would share De Zilwa’s views of Donald Trump’s approach to governance.[/caption]
The title of his article is inaccurate and even misleading and not supported by the information contained in annual road maps, monetary policy review statements and annual reports of the Central Bank in recent years. A reader of these will observe that the Central Bank of Sri Lanka actually commenced relaxing monetary policy in early 2019, and one could even argue that the process actually started in late 2018 with the reduction in the statutory reserve ratio of commercial banks in November 2018. In February 2019, the statutory reserve ratio was cut again, and in May and August 2019, policy interest rates were reduced by an aggregate of 100 basis points. In fact the cumulative effect of the cut in statutory reserve ratio in 2018 and 2019 is greater than the reduction that took place since January 2020, and if the policy rate cut in May 2020, which De Zilwa does not refer to, is ignored, the policy rate reductions in 2019 and 2020 are equal in magnitude. In addition to policy rate cuts, the Central Bank also imposed caps on interest rates, firstly on deposits and then on loans and advances in 2019 to speed up transmission and by the end of 2019 market interest rates were on a declining trend. Thus De Zylwa’s caption that suggests monetary easing to a recent phenomenon linked to the change in government is not correct. The continuing accommodative monetary policy stance fits in well with the present government’s policies but this is more coincidental.
The title also refers to an austerity mindset of the Central Bank. Low growth has been a persistent problem in Sri Lanka over several decades and whenever growth accelerated beyond 6 pc, this has generally been on the back of government spending of borrowed resources and/or import led consumption. Sri Lanka’s foreign direct investment record has been abysmal as has been the performance of our Exports. All of these factors taken together had the unintended but not unexpected consequence of putting the exchange rate under pressure. These negatives have not been as a result of flawed monetary policy. No amount of relaxed monetary policy could have countered the adverse impact on business confidence and the economy arising from decades of frequent policy reversals, intrusion of unviable and taxpayer subsidized state enterprises into all sorts of commercial activities, the low ranking in ease of doing business metrics, near impossibility of effectively enforcing contracts through an archaic legal administration and more recently a dysfunctional government during 2015 to 2019, attempted constitutional coup in 2018 and serious national security failures and the Easter Sunday terror attacks not to mention repeated floods and now a pandemic.
As a business cycle analyst De Zylwa would be aware that there are various phases of monetary policy, mainly tightening and relaxing. The monetary authority of any country, the Central Bank of Sri Lanka included, would be expected to confront and tame the economic public enemy No 1, which can change from time to time. In this connection, it is noteworthy that the Central Bank of Sri Lanka has always referred to a flexible inflation targeting policy and not chosen to target an absolute rate of inflation unlike some of the more advanced countries. It is expected that flexible inflation targeting, the indicated range being 4 to 6 % pa but to be agreed with the government from time to time, will allow the Central Bank some leeway in choosing its priorities but without losing sight of its statutory obligation to maintain price stability. Since poor growth (although not related to matters within the purview of the Central Bank) has been a concern in the last few years, commencing late 2018 the Bank commenced relaxation of monetary policy to stimulate growth despite the possibility of inflation edging up. This requirement has been amplified by the black swan events of the Easter Sunday attacks and the COVID pandemic and the Central Bank’s response to them. It is very apparent from various pronouncements made that the Central Bank’s main concern today is not inflation but providing liquidity to enable banks and business to tide over this period of difficulty and to stimulate the economy and the bank has demonstrated its commitment to this priority by further relaxing monetary policy in the period ahead until signs of recovery become visible. Once growth is picks up, if there are signs of overheating and inflation spirals upwards, that will at that time become the economic public enemy No 1 and it is expected that Central Bank will then take steps to bring it under control. It is well established that growth in a persistent high inflation environment will benefit only a small proportion of the population who have the ability to “inflation proof” their savings and invisibly robbing the poor and middle class population of the country. Such a growth strategy is neither sustainable nor equitable.
In the context of the foregoing De Zilwa’s reference to a hedonistic [Oxford Thesaurus: self-indulgent, pleasure seeking, lotus eating] inflation targeting regime by the Central Bank has no basis. De Zilwa has also picked on a populist critique to central banking by stating that the Central Bank’s framework is based on the notion that excess money supply or printing money causes galloping inflation. The publicly available literature will show that the Central Bank has moved away from monetary targeting, since it was not very effective and which inflation targeting central banks have little regard for. In reality, an analysis of the Central Bank’s actions over the last few years indicates that its flexible inflation targeting framework has been driven by both push factors as well as pull factors and not based on a “one dimensional approach” in circumstances where monetary targeting regimes practiced in the past were unsuccessful due to their deficiencies. On the other hand, the need for monetary policy to anchor inflation using an effective nominal anchor in lieu of exchange rate or money growth as nominal anchors, has caused Sri Lanka to adopt an inflation target as a nominal anchor, which seems to have worked well since 2009, and not just in the past 5 ½ years.
It is well known that Sri Lanka’s nominal and real interest rates are too high, and one reason for this is the overreliance of an increasingly ageing population on interest income for survival. These are structural issues that must be addressed by the government, but until that happens, socio political considerations will dictate that this need cannot be ignored. However, there is no argument that for the economy to revive, more conducive lending rates are necessary. What is surprising was that in Sri Lanka at a time when interest rates were equally high or higher than now in 2015, 2016, 2017 and 2018, credit was rising at a rapid pace, although GDP growth was not commensurate with the credit growth. This was possibly a key factor that prevented monetary policymakers from starting to reduce interest rates earlier. At a time when credit is galloping, a reduction in rates is barely necessary, and is likely to serve any useful purpose. The attempt by De Zilwa to link the NPL ratios of banks to high interest rates does not tell the real story. Empirical evidence will show that, barring external shocks such as COVID, NPL s have risen with a lag after periods of loose monetary policy depicted by high liquidity and low interest rates manifested in high credit growth and excessive leverage. Monetary policy tightening is the catalyst but not the cause of high NPLs and brings into focus the lax credit standards and poor risk management by banks and their borrowers during times of loose monetary policy.
[caption id="attachment_87161" align="alignleft" width="300"]
De Zilwa appears to advocate a traditional Keynesian and/or development economics mindset into monetary policy and central banking[/caption]
De Zilwa does not make any reference to the conditions of global financial markets and leakages from the Sri Lankan economy arising from imports and investment related outflows. Unless controlled artificially as is currently done, easy money tends to leave the country rather than being invested in Sri Lanka, not because of any fault of the Central Bank, but because of the weakened business sentiment due to policies and actions of successive governments over several decades.
De Zilwa appears to advocate a traditional Keynesian and/or development economics mindset into monetary policy and central banking. It would be interesting to see whether there is a single central bank in the world driven by traditional Keynesian ideology. Keynesian ideology is good for a government and the Treasury, as fiscal policy guided by Keynesianism may work well at the time of recessions, but it would have disastrous effects on a central bank if continued over time. New and modified Keynesian models are used by central banks throughout the world for monetary policy purposes, but this is merely to deal with market imperfections that are known to exist in otherwise market and private sector based economic activities. As for development economics, there are many public institutions to drive Sri Lanka’s growth and development, but there is only very few institutions like the Central Bank of Sri Lanka to preserve stability in the country. This division between development and stability objectives of institutions must be respected, while enabling coordination between such institutions for Sri Lanka to progress as one nation. In Sri Lanka, as well as in almost all other countries, central banks have been entrusted with the objective of maintaining stability in general price level, economy and/or financial system, as a member of the “monetary policy consultative committee”, De Zilwa will be aware of the Central Bank of Sri Lanka’s statutory obligation to do so.
De Zilwa refers to Donald Trump and his criticism of Federal Reserve monetary policymaking. It is doubtful that too many Sri Lankans would share De Zilwa’s views of Trump’s approach to governance. In any case, Trump has never criticized the Federal Reserve on its monetary policy framework which targets a 2% level of inflation in addition to an employment target, but has commented only on the level of interest rates. De Zilwa’s attempts to generalize the Japanese experience as a failure of inflation targeting is wanting. One can also look back at the disastrous results in Argentina early in this millennium when that country choosing exchange rates as the anchor for its monetary policy. Sri Lanka is neither Japan nor Argentina but it is doubtful that there is any Sri Lankan who would like Sri Lanka to replicate the economic performance of the latter. Out of the box thinking is very welcome as long as the actions that follow don’t put Sri Lanka into the coffin!
It is doubtful that too many Sri Lankans would share De Zilwa’s views of Donald Trump’s approach to governance.[/caption]
The title of his article is inaccurate and even misleading and not supported by the information contained in annual road maps, monetary policy review statements and annual reports of the Central Bank in recent years. A reader of these will observe that the Central Bank of Sri Lanka actually commenced relaxing monetary policy in early 2019, and one could even argue that the process actually started in late 2018 with the reduction in the statutory reserve ratio of commercial banks in November 2018. In February 2019, the statutory reserve ratio was cut again, and in May and August 2019, policy interest rates were reduced by an aggregate of 100 basis points. In fact the cumulative effect of the cut in statutory reserve ratio in 2018 and 2019 is greater than the reduction that took place since January 2020, and if the policy rate cut in May 2020, which De Zilwa does not refer to, is ignored, the policy rate reductions in 2019 and 2020 are equal in magnitude. In addition to policy rate cuts, the Central Bank also imposed caps on interest rates, firstly on deposits and then on loans and advances in 2019 to speed up transmission and by the end of 2019 market interest rates were on a declining trend. Thus De Zylwa’s caption that suggests monetary easing to a recent phenomenon linked to the change in government is not correct. The continuing accommodative monetary policy stance fits in well with the present government’s policies but this is more coincidental.
The title also refers to an austerity mindset of the Central Bank. Low growth has been a persistent problem in Sri Lanka over several decades and whenever growth accelerated beyond 6 pc, this has generally been on the back of government spending of borrowed resources and/or import led consumption. Sri Lanka’s foreign direct investment record has been abysmal as has been the performance of our Exports. All of these factors taken together had the unintended but not unexpected consequence of putting the exchange rate under pressure. These negatives have not been as a result of flawed monetary policy. No amount of relaxed monetary policy could have countered the adverse impact on business confidence and the economy arising from decades of frequent policy reversals, intrusion of unviable and taxpayer subsidized state enterprises into all sorts of commercial activities, the low ranking in ease of doing business metrics, near impossibility of effectively enforcing contracts through an archaic legal administration and more recently a dysfunctional government during 2015 to 2019, attempted constitutional coup in 2018 and serious national security failures and the Easter Sunday terror attacks not to mention repeated floods and now a pandemic.
As a business cycle analyst De Zylwa would be aware that there are various phases of monetary policy, mainly tightening and relaxing. The monetary authority of any country, the Central Bank of Sri Lanka included, would be expected to confront and tame the economic public enemy No 1, which can change from time to time. In this connection, it is noteworthy that the Central Bank of Sri Lanka has always referred to a flexible inflation targeting policy and not chosen to target an absolute rate of inflation unlike some of the more advanced countries. It is expected that flexible inflation targeting, the indicated range being 4 to 6 % pa but to be agreed with the government from time to time, will allow the Central Bank some leeway in choosing its priorities but without losing sight of its statutory obligation to maintain price stability. Since poor growth (although not related to matters within the purview of the Central Bank) has been a concern in the last few years, commencing late 2018 the Bank commenced relaxation of monetary policy to stimulate growth despite the possibility of inflation edging up. This requirement has been amplified by the black swan events of the Easter Sunday attacks and the COVID pandemic and the Central Bank’s response to them. It is very apparent from various pronouncements made that the Central Bank’s main concern today is not inflation but providing liquidity to enable banks and business to tide over this period of difficulty and to stimulate the economy and the bank has demonstrated its commitment to this priority by further relaxing monetary policy in the period ahead until signs of recovery become visible. Once growth is picks up, if there are signs of overheating and inflation spirals upwards, that will at that time become the economic public enemy No 1 and it is expected that Central Bank will then take steps to bring it under control. It is well established that growth in a persistent high inflation environment will benefit only a small proportion of the population who have the ability to “inflation proof” their savings and invisibly robbing the poor and middle class population of the country. Such a growth strategy is neither sustainable nor equitable.
In the context of the foregoing De Zilwa’s reference to a hedonistic [Oxford Thesaurus: self-indulgent, pleasure seeking, lotus eating] inflation targeting regime by the Central Bank has no basis. De Zilwa has also picked on a populist critique to central banking by stating that the Central Bank’s framework is based on the notion that excess money supply or printing money causes galloping inflation. The publicly available literature will show that the Central Bank has moved away from monetary targeting, since it was not very effective and which inflation targeting central banks have little regard for. In reality, an analysis of the Central Bank’s actions over the last few years indicates that its flexible inflation targeting framework has been driven by both push factors as well as pull factors and not based on a “one dimensional approach” in circumstances where monetary targeting regimes practiced in the past were unsuccessful due to their deficiencies. On the other hand, the need for monetary policy to anchor inflation using an effective nominal anchor in lieu of exchange rate or money growth as nominal anchors, has caused Sri Lanka to adopt an inflation target as a nominal anchor, which seems to have worked well since 2009, and not just in the past 5 ½ years.
It is well known that Sri Lanka’s nominal and real interest rates are too high, and one reason for this is the overreliance of an increasingly ageing population on interest income for survival. These are structural issues that must be addressed by the government, but until that happens, socio political considerations will dictate that this need cannot be ignored. However, there is no argument that for the economy to revive, more conducive lending rates are necessary. What is surprising was that in Sri Lanka at a time when interest rates were equally high or higher than now in 2015, 2016, 2017 and 2018, credit was rising at a rapid pace, although GDP growth was not commensurate with the credit growth. This was possibly a key factor that prevented monetary policymakers from starting to reduce interest rates earlier. At a time when credit is galloping, a reduction in rates is barely necessary, and is likely to serve any useful purpose. The attempt by De Zilwa to link the NPL ratios of banks to high interest rates does not tell the real story. Empirical evidence will show that, barring external shocks such as COVID, NPL s have risen with a lag after periods of loose monetary policy depicted by high liquidity and low interest rates manifested in high credit growth and excessive leverage. Monetary policy tightening is the catalyst but not the cause of high NPLs and brings into focus the lax credit standards and poor risk management by banks and their borrowers during times of loose monetary policy.
[caption id="attachment_87161" align="alignleft" width="300"] De Zilwa appears to advocate a traditional Keynesian and/or development economics mindset into monetary policy and central banking[/caption]
De Zilwa does not make any reference to the conditions of global financial markets and leakages from the Sri Lankan economy arising from imports and investment related outflows. Unless controlled artificially as is currently done, easy money tends to leave the country rather than being invested in Sri Lanka, not because of any fault of the Central Bank, but because of the weakened business sentiment due to policies and actions of successive governments over several decades.
De Zilwa appears to advocate a traditional Keynesian and/or development economics mindset into monetary policy and central banking. It would be interesting to see whether there is a single central bank in the world driven by traditional Keynesian ideology. Keynesian ideology is good for a government and the Treasury, as fiscal policy guided by Keynesianism may work well at the time of recessions, but it would have disastrous effects on a central bank if continued over time. New and modified Keynesian models are used by central banks throughout the world for monetary policy purposes, but this is merely to deal with market imperfections that are known to exist in otherwise market and private sector based economic activities. As for development economics, there are many public institutions to drive Sri Lanka’s growth and development, but there is only very few institutions like the Central Bank of Sri Lanka to preserve stability in the country. This division between development and stability objectives of institutions must be respected, while enabling coordination between such institutions for Sri Lanka to progress as one nation. In Sri Lanka, as well as in almost all other countries, central banks have been entrusted with the objective of maintaining stability in general price level, economy and/or financial system, as a member of the “monetary policy consultative committee”, De Zilwa will be aware of the Central Bank of Sri Lanka’s statutory obligation to do so.
De Zilwa refers to Donald Trump and his criticism of Federal Reserve monetary policymaking. It is doubtful that too many Sri Lankans would share De Zilwa’s views of Trump’s approach to governance. In any case, Trump has never criticized the Federal Reserve on its monetary policy framework which targets a 2% level of inflation in addition to an employment target, but has commented only on the level of interest rates. De Zilwa’s attempts to generalize the Japanese experience as a failure of inflation targeting is wanting. One can also look back at the disastrous results in Argentina early in this millennium when that country choosing exchange rates as the anchor for its monetary policy. Sri Lanka is neither Japan nor Argentina but it is doubtful that there is any Sri Lankan who would like Sri Lanka to replicate the economic performance of the latter. Out of the box thinking is very welcome as long as the actions that follow don’t put Sri Lanka into the coffin!