The Prince of Kandy
I am not saying it is a life and death matter when you print money. During my period it isn’t that we didn’t have excess printing but every time the treasury secretary asked me if we could accommodate the government with an excess of treasury bills I always got a date by which it was settled. We made sure that was settled. It is like a good bank manager. –Former Central Bank Governor Ajith Nivaard Cabraal[i]
To take on a loan one of the most important questions a bank will ask you is how you expect to pay it back? Loan applicants must submit business plans, offer collateral, provide credit histories, and offer lenders enviable access into their ledgers.
Banks try to forecast revenue streams to predict whether you can pay them back. For a business one would look at sales, for an individual one would look at salary, and for a government, one would look at taxation.
The Central Bank as alluded to by the former governor also has the capacity to fund the government. This funding comes in the form of seigniorage. By printing money, the Central Bank is creating assets for itself as the value of the money tends to exceed the cost of printing it.
By providing the government with increased purchasing power at the expense of public purchasing power, it imposes what is metaphorically known as an inflation tax on the public.
Given that the government is running a deficit estimated at 8.5 percent of GDP[ii] for 2020 at some point in the future it will have to raise tax revenues to pay the debt. This can be likened to someone planning to go on a diet.
A person choosing to exceed their budgeted caloric intake on one day must make economies on the next if their diet is to have an impact. In the same way, society impose judgments on people going on diets, we also are quite divided on the debt dynamics of a government.
Debt not only plays into intergenerational politics within society but also on issues such as class and regionalism. Whose burden it is to service the debt and for whose benefit the debt is created are highly politically divisive issues.
It however is economic orthodoxy that high debt is a risk factor for any economy. As an excessive diet may lead to things like heart disease an excessive debt burden can lead to for example severe fiscal constraints on the government, a run on the currency, insolvency, and a loss of business confidence.
Let us ignore the volume of debt on which as alluded to earlier we might be divided on given our varying demographic characteristics. Instead, let us draw our attention to the cash flow implications of debt servicing.
Sri Lanka is not Japan. Japan’s debt is denominated in its local currency and they with their long-lasting export-strength have built up reserves and stakes in important global institutions like the Asian Development Bank. Sri Lanka is not the United States. The United States has hegemonic power over energy, military, and international institutions and is the global reserve currency.
If our debt dynamics become worse, we are likely to face further downgrades to our already dangerously weak credit rating. This will skyrocket the cost of debt and thus the cost of projects requiring external financing. In simple terms, if our debt dynamics weaken the costs of developing roads sans the political commission will become even higher than they are now.
In terms of going concern the sovereign is treated differently than a legal entity or person. Markets value sovereign debt based on cash flows and reserves in a more forgiving manner. This is odd because if entities had the same wastage, excesses, and grandiose plans as the government markets would surely be closed to them.
This is to say that the markets assume that even if Sri Lanka is to default on debt payment it would continue to exist the next day. For instance, land in Greece still has a positive value. Having defaulted Greece can both issue new debt and retain ownership of their assets. Greece does not become part of Germany just because it has defaulted to Germany.
This contrasts with let us say when one of our many highly indebted holding companies goes insolvent or worse bankrupt and though they may have viable subsidiaries it is difficult for them to part with the asset without their creditors getting worked up.
Imagine learning that you have lost your wallet on public transport. Regardless of what you look like you will quickly be treated as if though you are as a busking beggar. You will most likely be asked to get down at the next stop.
Here Sri Lanka’s borrowing to China is important as though they insist that the terms are good it does not happen through the same channels as traditional lenders. Traditional lenders like the Asian Development Bank have established offices and interface with the treasury with well-established formal procedures whereas the Chinese come through promoters and the political system.
This is most exemplified in the Central Expressway. Chinese financiers linked to the state won contracts[iii] on the expressway and subsequently withheld funds and delayed progress on the infrastructure. On the return to power of their political puppet,[iv] they will resume the project.
Intelligent Economic Policy
This can become an economic crisis. Not only big countries but also small countries have Central Banks that have acted. In the US they have taken a US $ 600 billion action. The US Federal Reserve commits to use the full range of tools to help the economy through unprecedented times. What has our Central Bank done? Nothing. Our Central Bank does not use a single tool they just sleep. Give Rs 150 billion to these businesses.
Due to the mistakes of the past, there are debts owed by the government to companies. Let companies collateralize that debt to run the economy. This is money circulation. This is the basics of economics.
Your mistakes are perceived to be that of the government. Look at the failure of the finance companies, it is the fault of the Central Bank. All of you are economists who take large salaries. You have a duty in this crisis to act.President Gotabaya Rajapaksa[v]
These statements look to deflect heat towards the Central Bank which does not have to stand for election and suggests that the Central Bank is behind the economic failings of the interim government. The monolithic media structure backing the SLPP has gone on overdrive under the premise that the public is concerned with a cricket match played in 2011 to deflect from the massive economic failings of the government.
Central Bank actions, directly and indirectly, influence monetary aggregates. Monetary transmission in Sri Lanka takes about six months. In other words, it takes time for the major levers of Central Bank policy to have an impact on the economy.
Ignoring the health risks to improve cash flow in the economy it would have been more effective to open the economy. It would have been even better if the COVID-19 relief fund were distributed earlier as opposed to just before an election.
Fiscal policy is a much better tool and the interim government had already exhausted that measure through their massive tax handouts. These policies were a joke with VAT reductions not resulting in price reductions.
Developed countries could take larger action proportional to their economies because they had built reserves that our Central Bank has not.
We live in a country where the two major spenders in the upcoming election (the SJB and SLPP) are dogged with huge corruption scandals. The SJB leader spent the central cultural fund as if it were his own and the party of the current interim government’s scandals are well known. Parliament will have its fair share of idiots and they will invariably push the country into more tender fraud.
We live in a country wherein despite considerable evidence to the contrary people watching the news at 7 feel informed. They watch as newscasters picked mostly on the sole basis of their sexual appeal speak on the eve of an election on whether a cricket match played in 2011 was rigged. A bipartisan opinion would agree that the cricket administration is corrupt but would also agree that cancer will cross the political aisle.
We are not a country that is capable even after the President makes a big deal of the Central Bank to consider the fact that the deposit cost of funds to the banks has reduced further than their average lending rates to the economy. Ignoring impairment during the crisis the net interest margin of the banks widened.
Central Bank Stupidity
Sri Lanka’s commercial banks are at present in a state of massive excess liquidity. They are sitting on a huge amount of cash but there are no matching loan applications to dispense it. Hence, on a day to day basis, they have been parking their excess cash in an interest-earning deposit with the Central Bank under its Standing Deposit Facility or SDF at 5.5%. At the time the Board decided to cut SRR by 2%, the banking sector was with excess liquidity of about Rs. 100 billion which they had deposited with the Central Bank under SDF. –W A Wijewardane[vi]
Instead of going into the secondary market on long term government securities and providing the economy with a true monetary stimulus that ordinary businesses can use the Central Bank chose to create liquidity for wheeler-dealers looking to make a quick buck as foreigners escape our banana republic.
The construction sector will require a nuclear level of money printing to be bailed out. It is the only sector in the country that imports manual labor and the signs that it has overheated are clear to any casual observer. Take the Labour Department building amongst many others which is for the most part empty while the government continues to procure more building space at a ridiculously high spec.
Debt Management of the Government
The Central Bank management of Government debt has been concerning for decades now. There are huge conflicts of interest in the issuance of debt for the government by the Central Bank.
Despite several public statements made in recent years about plans for the management of government debt to be transferred to an independent agency, no progress appears to have been made. Whether this is due to bureaucratic inertia or active resistance to change by vested interests, the net result is slow progress on modernizing capital markets. – Arjuna Mahendran 4 July 2020[vii]
Consider the way monetary aggregates are being increased and the quality of government securities. The General public would find it very difficult to get government securities. The primary dealer network is very poorly regulated. Though people lead by the quite weak financial press may look to focus on Perpetual Treasuries they fail to remember Entrust Securities. Entrust Securities put to question the entire issuance system established by the Central Bank. Ignoring those two institutions we also have stand-alone Primary Dealers who pose significant counterparty risk to the system and have exposure to the microfinance sector.
Given the Domestic Operation[viii] Directive on 3 July the Central Bank has gone from completely messing up government debt issuance to outsourcing it to the government. This allows the government without going to parliament to issue Promissory Notes that the Banking Sector must recognize. This effectively creates money and hands that power directly to the Minister with no checks and balances. The Central Bank loses control of Monetary Aggregates in the system.
The Monetary Board has approved a ‘Liquidity Facility to the Construction Sector’ (LFCS), … for the construction sector enterprises to borrow from LCBs, backed by a ‘Letter of Acceptance of Payments of Outstanding Bills Due to Contractors” (LAPC)… In turn, Licensed Commercial Banks provide promissory notes secured by pledged Treasury Bills and Treasury bonds in their holding to the CBSL to obtain credit facilities at a concessionary rate of interest. – Operating Instructions No: 35/03/023/0001/002Domestic Operations Directive Operating Instructions No: 35/03/023/0001/002
The above quote was a directive sent to all bank CEOs. The economic consequences of a delay to the construction of a bridge or road pose a much smaller existential threat to the construction industry than for instance the ability of a bakery to keep its doors open the next month by paying it’s bakers a salary. Why is it so pertinent that the construction sector be bailed out first? My take is that the workers in those industries tend to be Chinese and that is where the government seems to be seeking credit.
When Greece was bailed out by the European Central Bank those funds were used to pay down Greek bonds that apart from the stock that we managed to get our hands on were held by German banks. Power is what gets bailed out. The bailout to the construction sector already makes the SME bailout seem miserely.
Solving the Cash Problem
The financial markets identified the problem as one of cash flow early on. Why did not the Central Bank look to fix that issue? Let ordinary people withdraw from their time deposits with no penalty. Let employers delay their EPF contribution or divert those funds directly to the employee. Invest EPF funds in the stock market to boost liquidity and take advantage of low prices.
Reducing the statutory reserve ratio still requires the banks to intermediate to get cash into the real economy. That takes time. It also is unsustainable as the rate will invariably have to rise and with no timelines on when this will happen it will be driving more uncertainty into banking decisions. As alluded to before this move only exists to get money into the hands of wheeler-dealers to be put on the stock exchange or into the election.
Reserves are not just a tool to control monetary aggregates but also ensure banking stability. With such a low rate is the Central Bank risking the entire payment system?
Given that the Central Bank details the debts of the government and when they mature it is easy to predict that whichever government comes into power, they will have to implement a high tax regime[ix].
Inland Revenue has been clever and pushed through a new system for Income Tax[x]. Commendations are due as this system will make it more difficult for people to lower their effective rate of taxation and not disclose income.
In the past, people would only be subject to WHT on their formal instruments and would receive payment in cash for their clinic or legal services. Inland Revenue could not feasibly investigate people. Under the new system, any formal instrument would be a giveaway as through the submission of a statement of estimated tax you would no longer be lying through means of omission and actively misleading the government.
Thresholds were lifted so people would lose concern in income taxation and shall be shocked when they realize that both thresholds and the system have changed. The tax code will have to be retrospectively enacted. This is an election year. Do not buy into the marketing. As stated earlier you should be getting out of taxable assets.