Part II: Central bank policy interest rates without any macroeconomic rationale – Why monetary controls miserably fail
- central bank policy interest rates are overnight or very short-term risk free rates on central bank’s money printing-based credit operations,
- credit operations of the rest of the monetary economy are taken place at various degree of risks,
- interest rates are the prices of risks such as real business and inflation and,
- therefore, policy interest rates-based monetary policy cannot drive market interest rates and credit flows unless central banks implement risk sharing and mitigation tools in the monetary policy.
- Standing lending facility only up to 90% of the SRR of the bank on the day.
- Standing deposit facility only up to 5 days/times a month.
- First, this is not a new liquidity injection, but only an increase of free reserves of banks at the existing liquidity. The new liquidity comes only from the money printing by the CB which continues with reverse repo auctions and lending to the government.
- Second, there is no basis to state that bank credit flows will expand. It is the old monetary theory to state that credit creation will expand due to SRR cut and vise versa on the assumption of credit as a byproduct of deposits. According to the modern monetary theory, if there is demand for good credit, banks can first lend through book entries and then find the liquidity from other sources inclusive of money market and borrowing from the CB as part of managing the liquidity of the whole bank. Therefore, bank lending is not a business carried on pre-deposit mobilization whereas deposit business in fact is a byproduct of credit business in modern banking. Therefore, it is incorrect to state that banks will expand credit just because of the SRR cut as the CB states.
- Third, the SRR cannot influence in interest rates on bank credit business as the SRR cannot determine and affect credit risks of bank borrowers and the economy. Everybody knows the alarming credit risk in the current context of the economic bankruptcy and impaired credit and investment portfolios of the banking sector.
- 18% on pawning facilities
- 23% on pre-arranged temporary overdrafts
- 28% on credit card balances
- In respect of other credit facilities (both new and existing) whose interest rates are less than 13.5%, a reduction of interest rates as least by 2.50% by 31 October 2023 and by further reduction of 1% by 31 December 2023
- Reduction of penal interest rate on all credit products immediately to a level not exceeding 2%
- Interest rates are fixed by pricing the risks of credit products. However, the CB does not have a mechanism to gage the maximum risk each product encounters in order to fix the maximum interest rates. Further, the CB does not operate any credit risk insurance or mitigation measures to ensure that maximum risks are consistent with maximum interest rates. Therefore, setting of numerical limits on interest rates is meaningless.
- The order refers to recent cuts in policy interest rates (by 4.5%) and SRR (by 2%) as the basis for the reduction in market interest rates. However, as pointed out above, risk free policy interest rates and bank reserves are not a basis for affecting interest rates on risky credit products unless the CB provides credit risk mitigation instruments such as refinance and credit guarantees.
- The order also refers to the considerable easing in monetary conditions where interest rates of banks and financial institutions remain excessive and are not in line with current monetary policy stance. This is a flawed statement due to several reasons.
- First, liquidity shortages reported from the bankrupt economy (i.e., government, banks, businesses and households) does not show any easing of monetary conditions. The CB does not give supporting figures to justify this order. In contrast, the fact that M2b annual monetary growth has declined from 16% in July 2022 to 6.2% in July 2023 and the reduction of the monetary base/reserve money from Rs. 1,436 bn in July 2022 to Rs. 1,374 bn in July 2023 (annual growth reduced from 35% to negative 0.9%) proves the opposite of the monetary easing. Therefore, the base statement in the order itself is flawed.
- Second, high interest rates structure at present is in fact is a result of excessive interest rates forced by the CB through Treasury bill rates pushing from around 8% at the beginning of 2022 to around 32% towards the end of 2022 and default of public debt management. The CB also issued a monetary order on 21 April 2022 to remove maximum interest rates that prevailed at that time on credit card balances, pre-arranged temporary overdrafts and pawning advances and to force banks to raise interest rates of all banking products. However, the CB has just forgotten its reckless history and now blames banks for high interest rates. The CB unnecessarily mentions excessive interest rates charged by financial institutions although the order does not apply to them.
- If banks comply with these interest rates ceilings due to unofficial threats of the CB being the bank regulator, they will immediately cut credit flows and entertain only customers and economic activities of lowers risks. This in fact will slow down credit expansion and will be a severe blow to the recovery of the economy already contracted by the unnecessarily tightened monetary policy pursued by the CB since the beginning of 2022, despite the economic crisis.
- CB monetary policy economists must be well aware from both market economic principles and recent experiences that such maximum interest rates imposed for reducing the interest rates structure invariably fail. The plight of the most recent interest rates caps is as follows.
- As per monetary order dated 26 April 2019, deposit rates up to 3 months were linked to standing deposit facility rate less a margin of 0.50% and other term deposits were linked to 364 day Treasury bill yield rate less 0.50% to plus 2.5% across the tenure. This was supported with a SRR cut of 2.5% to enhance the efficiency of the monetary transmission mechanism and expand credit flows. However, the order was withdrawn on 24 September 2019 after 5 months.
- In contrast, a monetary order was issued on 24 September 2019 prescribing caps on lending interest rates on grounds and characteristics similar to the present order, for example, 28% on credit card advances, 24% on pre-arranged temporary overdrafts and reduction of penal interest rate to a level not exceeding 4%.
- The caps were further reduced by the monetary order dated 21 August 2020 in view of the ultra relaxed monetary policy for the Corona-affected economy, i.e., 18% on credit card advances, 16% on pre-arranged temporary overdrafts, 10% on pawning and reduction of penal interest rate to a level not exceeding 2%.
- All these caps were removed by the monetary order dated 21 April 2022 stated above as part of the high interest rates policy of the CB.
- The monetary order does not contain a mechanism to ensure the compliance including the penalties in terms of the legislation. Further, the latest order issued on 28 August 2023 has not revoked the previous order dated 21 April 2022 and, therefore, banks have the option to choose the order they prefer. Therefore, abuses are unavoidable.
- The CB just look at monthly consumer price index-based statistical/annual inflation numbers and announces these bureaucratic price controls by resorting to the old monetary theory and waits till the next shock to the economy.
- The recent history of such monetary policy tools (risk free policy rates model and price controls cited above) shows that they cannot influence various classes of credit risks confronted by modern monetary economies that operate on credit markets. Further, the CB does not have data to establish the effectiveness of such tools in the past.
- As the CB does not implement any monetary tools to amend credit risk structure of economic activities, the present monetary policy model and money market control tools are baseless on macroeconomic grounds.
- Therefore, monetary policy decisions of the CB are nothing but reopening of the old files to mislead the national leaders that the CB is dynamically engaged in recovering the bankrupt economy through enhanced monetary transmission mechanism and credit flows across the economy where the policy statements are nothing but meaningless words meant only for relevant economists and officials of the CB.
- In that context, the CB’s monetary policy is not in a position to help recover the bankrupt economy unless it invents tools that are efficient in sharing and mitigating credit risks of priority sectors and activities. However, the CB is able to make billions of profit on its risk free monopoly money printing business carried out on very short-term basis with wholesale money dealers.
- The danger of the attempt to implement such baseless policy tools and false statements is the uncertainties and bottlenecks created in markets and adverse impact on the recovery and stability of the economy. The literature on abuses of such bureaucratic controls at levels of both market participants and authorities is well known.
- In general, unlike in developed market economies, interest rate is not a material factor to drive credit flows in Sri Lanka. What most matter are the access to credit and risks. Therefore, such credit market control tools will only be on the paper amongst the countless number of regulations relating to economic activities.
- Interest rates/yield rates of government securities are well within the direct control of the CB. Therefore, the CB’s normal practice has been to set the yield rates in order to influence in interest rates in credit markets. However, the CB does not seem to reduce weekly Treasury bill yield rates during the past two months but sets ceilings on bank interest rates. Therefore, the CB should set the example for lower interest rates by first cutting the yield rates of government securities operating at its hand.
- Therefore, national leaders are advised to think twice whether this is the national monetary policy that the country needs at this juncture to recover the public from the present bankruptcy as the monetary policy is not a rocket science but a concept-based intervention in the monetary side of the economy by the government for the benefit (creation of wealth and living standards) of the general public.
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