The rapid growth of the money supply propelled by substantial bank loans to the government since last year has been a major cause of economic stability. The Central Bank has no room for maneuver to mop up this excess liquidity, in the absence of fiscal discipline. The Roadmap did not pay attention to this critical issue
The six-month roadmap to securing the stability of the macroeconomic and financial system presented by central bank governor Ajith Nivard Cabraal earlier this month contained a long “to-do list” that goes beyond monetary policy, as I explained in the FT Column (https://www.ft.lk/columns/Central-Bank-s-Road-Map-lacks-monetary-policy-framework-avoids-IMF-bailout/4-723902 ).
A policy statement with a strong monetary policy framework setting out specific goals, targets and instruments would have been more appropriate, rather than a long slide show.
Ignored economic imbalances
Monetary policy would be futile if it is not tied to strict fiscal targets. Government borrowing needs continue to increase, heavily dependent on Treasury bills and bonds and foreign commercial loans. Treasury bill auctions have been underwritten although yield caps have recently been removed. The purchase of the unsold portion of Treasury bills by the central bank leads to an increase in its monetary base and, in turn, in the money supply. The resulting inflationary pressures are already evident.
The exchange rate remains fixed as stipulated in the Roadmap, despite the severe shortage of foreign exchange exacerbating the anti-export bias. Foreign exchange reserves are reduced to minimum levels relative to future external debt commitments.
Monetary expansion continues
The rapid growth of the money supply propelled by substantial bank loans to the government since last year has been a major cause of economic stability. The Central Bank has no room for maneuver to mop up this excess liquidity, in the absence of fiscal discipline. The Road Map did not pay attention to this critical issue.
Immediately after the presentation of the roadmap, the Central Bank’s holdings of government securities increased by 8% from Rs. 1.336 billion to Rs. 1,443 billion (Chart 1). This increased the monetary base (adjusted for net foreign assets) causing an expansion of the money supply.
The underwriting of the treasury bill auctions held as a result of the roadmap indicates that the slightly increased threshold rates of return are insufficient to sell the entire stock of bills in the market. The balance portion of treasury bills was to be purchased by the central bank, causing an increase in its monetary base and, in turn, the issuance of currency, commonly known as money printing. The overall money supply has increased by 10 times the money base due to the money multiplier effect.
Year-on-year inflation, measured by the Colombo Consumer Price Index (CCPI), reached 5.7% last month from 4.0% a year ago (Chart 2). Maximum retail prices for several essentials including rice, wheat flour, powdered milk and LPG gas were removed last week and as a result inflation will accelerate further in the coming weeks. .
Monetary expansion resulted in excess market liquidity which put pressure on aggregate demand. These unfavorable trends clearly show the imminent danger of adopting the so-called modern monetary theory policy by the Central Bank to fill budget deficits by printing money, as I argued in a previous FT column (http: / /www.ft. lk / columns / Money-printing-to-repay-Govt-debt-worshiping-MMT-is-likely-to-amplify-economic-instability / 4-710612).
Against the backdrop of supply shortages due to the pandemic and import restrictions, inflationary pressures are escalating further. Another factor that has caused inflation to rise on the cost side is the depreciation of the rupee. With the depreciation of the rupee, imports become more expensive, and as a result, the prices of consumer goods that constitute a significant part of the consumer basket will continue to rise, thus accelerating inflation.
In addition to these direct effects of the depreciation of the currency, other cycles of monetary expansion will take place due to a possible increase in the budget deficit due to the increase in public expenditure induced by the depreciation of the rupee.
Exchange rate distortions
Higher domestic inflation relative to the inflation of trading partners leads to an appreciation of the real effective exchange rate (REER) putting exporters at a disadvantage. Therefore, he calls for a depreciation of the rupee to support the competitiveness of exports.
However, the roadmap contemplates: “Considering the REER, maintain the rupee at the very competitive level of Rs. 199 to Rs. 203 against the US dollar over the next three months, and review thereafter. Commercial banks have adhered to the fixed exchange rate rule despite the severe shortage of dollars in the market.
Meanwhile, CBSL allows an additional Rs. 2 to be paid per dollar handed over and converted by overseas workers. This discriminates against other sources of foreign currency income, especially exporters. This type of dual exchange rate system was in effect during the pre-liberalization period.
The fixed exchange rate system prevents necessary market adjustments in the context of an overvalued rupee. The unrealistic exchange rate has led to the development of a parallel black market, as admitted by CBSL itself in its recent press release (https://www.cbsl.gov.lk/sites/default/files / cbslweb_documents / press / pr /press_20210927_rapatriation_and_conversion_of_export_proceeds_e.pdf).
Attractive black market rates tend to divert foreign exchange earnings, including worker remittances, from formal channels to informal money transfer programs (IMTS) such as “Hawala” and “Unidyal”.
It would be difficult to keep the exchange rate fixed for long as the central bank does not have sufficient foreign exchange reserves to defend the rupee. Therefore, a substantial depreciation of the rupee is inevitable, which would be more painful than gradual adjustments reflecting market conditions.
It is reported that some exporters decided not to bring the export earnings to Sri Lanka by defying the Central Bank export earnings conversion rule. They are of the opinion that it is advantageous for them to pay tax at 28% instead of 14% as warned by the governor of the Central Bank, rather than converting export earnings at the fixed exchange rate. unrealistic.
Exporters have also expressed their displeasure at the governor’s statement that they are accumulating foreign currency abroad.
Investors not convinced
The roadmap does not appear to have had a significant impact on improving market sentiment, as it lacks a coherent macroeconomic framework aimed at stabilizing the economy.
Global financial giant City has indicated that the downside risks are higher despite the Central Bank’s roadmap, as Sri Lanka would not be able to restructure its debt obligations without IMF help. Citi believes the roadmap contains a little less clarity and longevity than some investors wanted. In these circumstances, Citi decided to remain neutral in terms of credit on Sri Lanka.
A credible reform program is the urgent need to rectify macroeconomic imbalances and gain investor confidence.
In this regard, improving the country’s debt sustainability is essential. In terms of Global Debt Sustainability Assessments (DSAs), Sri Lanka is identified in the “extremely speculative / substantial risk” category along with seven other countries: Angola, Congo, Congo DRC, Gabon, Lao PDR, Mali and Mozambique.
It would be impossible to improve debt sustainability without appropriate fiscal reforms aimed at reducing the fiscal deficit.
(The author is Emeritus Professor of Economics at the Open University of Sri Lanka and a former central banker, contactable at [email protected])