ECONOMYNEXT – The finance ministry, which runs budget deficits, and the central bank, which compounded fiscal debacles by printing money, are the main sources of macro-economic instability in Sri Lanka, economists said.

Sri Lanka’s Finance Minister (who has the power to spend large volumes of money suddenly without taxing people) and the Governor of the Central Bank (who has a monopoly in creating new money) are responsible for maintaining economic stability in the country.

Irresponsible 

"Unfortunately, these two positions were the main sources of macro-economic instability in the country," W A Wijewardene, a former Deputy Governor of the Central Bank, told an economic forum in Colombo.

A revised budget in 2015 was probably the worst since a budget for 2004 was de-stabilized by a new administration by printing money, sending the rupee down to 105 from around 94 and inflation to 20 percent from zero as the US Fed fired a commodity and housing bubble with low interest rates.

In 2015, the rupee collapsed from 131 to 147 (with the US tightening policy amid a subdued banking sector in that country and commodity prices being benign) as over Rs200 billion was printed to finance the budget deficit and accommodate fleeing capital.

"My assessment is that the excesses of the Rajapaksa years had not been fundamentally corrected so far, and in some respects it had got worse," Razeen Sally, a plain-speaking international economist who now chairs Sri Lanka’s Institute of Policy Studies said.

"We had, in my view, two very bad budgets last year. There has been excessive increases in public sector spending, on salary increases and new entitlements. The tax system has continued to deteriorate.
 
"There had been too many ad hoc measures on taxation. Business is understandably very vexed because of the high levels of unpredictability and uncertainty that continue from the last regime."

Compounding Errors

Sri Lanka imposed retrospective taxation on firms in 2015, extending the harm to the country’s image as a safe investment destination by building on the negative effects of Rajapaksa-era expropriations.

"Monetary policy in my view was far too loose following the excesses of fiscal policy," Sally said.

"I welcome very much the excellent appointment of the new Governor (of the Central Bank). I think he understands the situation very well… The task of central bank is fundamentally is to ensure macro-economist stability, at its core price stability – not to compound the errors of fiscal policy."

Newly appointed Central Bank Governor Indrajit Coomaraswamy said the country seems "to be on the cusp" of putting measures for sustained growth and development.

He said both with Finance Minister Ravi Karunanayake and President Maithripala Sirisena underlined the need to fix budget deficits.

"If you look back at the last 30 years, that has been the main source of instability." Coomaraswamy said. 

"So if we can crack that, we are able to create the kind of foundation that is necessary for the private sector to invest, create jobs and thrive."

Punch Bowl

Wijewardene said, by raising policy rates 50 basis points last month, Coomaraswamy had sent a clear signal that the liquidity-driven party was over.

"If you look at the main ailment in the country in the past – it’s like we had invited the whole population of Sri Lankans to dance on the dance floor without knowing how they might be able to perform the next day," Wijewardene explained.

"There was a big punch bowl and it was filled by the central bank by printing money."

Analysts had warned that the most dangerous monetary policy tool of the central bank, which is not even formally mentioned as tool, is the rejection of real bids for Treasury bills at auctions and buying them up at low rates to keep rates down, generating inflation and balance of payment troubles.

Wijewardene was echoing the words of William McChesney Martin, who was made the Governor of the Federal Reserve by President Harry Truman and promptly went about tightening policy and ending the obligation for the Fed to buy Treasury bonds.

Truman reportedly called him a ‘traitor’ after meeting him in the street later.

Budget Surplus and Inflation

McChesney Martin brokered the so-called ‘Treasury – Fed accord’ while he was Deputy Secretary of the Treasury in 1951, allowing the Fed to raise rates stop the global commodity bubble it was firing as the Korea War threatened to escalate.

Analysts say it is important to keep in mind that monetary instability in the form of inflation and currency collapses are not really fiscal in nature, although deficits are often blamed.

A rise in government spending or a budget deficits will not create monetary instability by itself as it simply an exercise in re-allocating resources in the economy.

An increase in state spending financed by taxes will re-allocate spending from probably higher return private projects to lower return state ones, reducing growth.

Deficit spending financed by borrowings will also re-allocate resources to the state and push up interest rates. Miss-spent state fund (such as subsidies or bad projects) will generally lower growth as happened during five year plans of the Soviet Union and India.

A deficit will create inflation and balance of payments trouble only if the central bank prints money to accommodate it and keep rates down to boost credit artificially with ‘legally counterfeited’ fiat paper money.

"[We are making] it possible for the public to convert Government securities into money to expand the money supply.. . ," Federal Reserve Governor Mariner Eccles said in 1951 in meeting minutes later made public during its battle with the Treasury to avoid buying war bonds.

"We are almost solely responsible for this inflation. 

"It is not deficit financing that is responsible because there has been surplus in the Treasury right along; the whole question of having rationing and price controls is due to the fact that we have this monetary inflation, and this committee is the only agency in existence that can curb and stop the growth of money.. . . 

"[W]e should tell the Treasury, the President, and the Congress these facts, and do something about it.. . ."

Sri Lanka has also resorted to price controls are printing money, further hurting small businesses and undermining the country’s policy credibility which economists say was a supreme idiocy. In the 1970s, money printing, exchange controls and price controls led to widespread shortages and blackmarkets.  (Colombo/Aug08/2016)