CB Annual Report 2016: Bold in critical analysis and proactive in policy recommendations

Release of CB Annual Report 2016

The Monetary Board released its Annual Report on the state of the economy in 2016, commonly known as the Central Bank Annual Report, two weeks ago. The Governor and the senior officers of the bank had in person handed the copies of the report to the three key persons in the administration - the President, Prime Minister and Minister of Finance at three separate meetings. Meeting them personally to hand in the report would have served two purposes. 

Need for coming out with a realistic assessment of the state of the economy

One would have been the opportunity the Governor and others got to keep the three key personnel informed of the true state of the economy – a crisis by any standard – at the present juncture. The other would have been to draw their attention to the main policy reforms which the report has recommended for adoption if the Government wishes to come out of the crisis permanently. 

In fact, the role of the Monetary Board has been to give this advice to the Government impartially and objectively taking an apolitical stance.

Finance Minister N.M. Perera wanted CB to be impartial and objective

That was the piece of wisdom which the left-wing Minister of Finance, Dr. N.M. Perera or NM, left with the Central Bank senior staff when he addressed them in 1971, according to a report in Ceylon Daily News and reproduced by the bank in its 60th Anniversary Commemorative Volume. 

NM is reported to have said that the bank should make “independent reports on economic subjects to the government and not reports (that) merely suit the political complexion of the government in power” and “he would value reports (of the bank) made dispassionately and objectively.” 

NM’s wisdom should not be ignored

NM’s wisdom contained in this piece of advice should enlighten all his successors since then as to how they should deal with the Central Bank. Thus, a finance minister with foresight and wisdom should not get offended when the Central Bank makes a critical analysis of the prevailing state of the economy. Indeed, he should welcome such critical analyses since they allow his government to take remedial measures before it becomes too late.

CB should not be a policy owner

The current annual report could be rated as a departure from the annual reports released by the Central Bank in the immediate past few years. Those reports, as this writer had observed in a previous article in this series (available at: http://www.ft.lk/article/382895/To-regain-lost-credibility--Central-Bank-should-act-as--impartial-spectator--and-not-as--policy-owner- ), had analysed the economic situation having taken ownership of the policies implemented by the government. Such analyses made by the bank as an insider of the government had denied it of the opportunity for being an “impartial and an objective critic”. It not only caused to mislead the Government in power but also to misinform the members of the public. 

Minister of Finance should respect CB’s role

The Central Bank has been created by society to function as an apolitical institution and not a branch office of the political party in power. It can perform this role only by being an outsider and not an insider. 

The government in power, especially the Minister of Finance, should appreciate this role of the bank. There is ample historical evidence in Sri Lanka as well as in other parts of the world that a subservient Central Bank is the main cause of the downfall of the government in power. In the opposite, an independent central bank would help a Government to identify its own follies and take corrective action in time.

AR is a product of a ‘collective brain’

The Annual Report of the Central Bank is a joint production by the economists of its Economic Research Department working on the direction of its Director. They are being supported by all other departments in the bank by supplying data and making analyses of given economic issues. 

The work relating to the data collection and analysis starts in about October in every year and goes on till about March of the following year. The preliminary reports prepared by junior economists are vetted and edited by senior staff causing an endless back and forth movement of drafts before they are submitted to the Monetary Board as a final product. Thus, it is not a single brain with a single view that contributes to the production of the annual report. Rather, it is done by a multitude of brains with differing views on economic issues. Hence, all officers in the Economic Research Department should get credit for the success or blame for the failure of the annual report.

A reader can get the gist of the report from the first chapter alone

The first chapter of the report, a preserve of the Director of Economic Research, is in fact an executive summary of what is presented in subsequent chapters plus a run-through of the economic weaknesses and the necessary remedial measures which the Government should take. Hence, if anyone reading only this chapter will enable him to make a realistic grasp of the state of the economy and what action should be taken to remedy the ailments. 

A frank admission of the sorry state of the economy

The first chapter in AR 2016 starts with a candid admission of the poor performance of the economy during 2016 on all fronts. Growth has slowed down from 4.8% in 2015 to 4.4% in 2016; per capita income, which has increased in rupee terms from Rs. 522,355 to Rs. 558,363, has fallen in dollar terms from $ 3,843 to $ 3,835 due to the depreciation of the rupee. Inflation, measured in terms of the Colombo Consumers Price Index, has accelerated from 2.2% in 2015 to 4% in 2016; to make matters worse, core inflation which is free from weather or price control effects on food items and, therefore, measures the level of the money aggregate demand is on the increase; though the budget deficit has been contained at 5.4% of GDP in 2016, the central government debt has increased from 78% of GDP in the previous year to 79% of GDP in 2015; exports have declined, trade deficit has expanded and the balance of payments has recorded a deficit for the second consecutive year; the rupee has been under pressure for depreciation, while foreign reserves have declined from $  7.3 billion at end-2015 to $ 6 billion at end-2016. 

Warning to the government: address the deep-rooted structural issues promptly and consistently

All these numbers demonstrate a worsened macroeconomic imbalance in the country which started to show itself up as from around 2012. Based on these findings, the report has given the first warning to the government: address the deep-rooted structural issues if the country is to progress steadily toward a higher growth trajectory. 

This higher growth is the attainment of a minimum of an average annual growth of 7% over the next 30-year period as envisaged in the Economic Policy Statement delivered by Prime Minister Ranil Wickremasinghe in Parliament in October 2016. If this growth rate could be sustained by Sri Lanka over the next 30 year period, it could increase its national output by about eight times of what it is today and join the rich country club by about 2045. 

The report has emphasised that the necessary policy package involves attracting foreign direct investments, boosting local investments and joining global production networks. This policy package, says the report, should be started swiftly and implemented with consistency. These recommendations fall in line with what this writer recommended in a previous article published in this series just before the onset of the current year (available at: http://www.ft.lk/article/587456/Economy-2017--The-alarming-signs-should-not-be-ignored).

Admission of the folly of abolishing ‘direct placement system’

A very bold feature in the Annual Report 2016 is the admission by the Monetary Board, for the first time, that abolition of the direct placement system by the bank in February 2015 has had a deleterious effect on its ability to manage interest rates on government securities in the two years that followed. 

Says the annual report: “The impact of replacing the mixed system of auctions and direct placements to raise funds for the Government with a purely auction based system where direct placement of Treasury bills were made only with the Central Bank, also contributed to the increase in interest rates on government securities (pp 15-6).” 

An unintended consequence of the abolition of the direct placement system, according to the CB annual report, has been the elevation of the whole interest rate structure in the financial system. Thus, the cost has been borne not only by the Government but also by the private sector. 

Past Monetary Boards justified the abolition of direct placement system

When this writer made the same observation in a previous article in the series (available at: http://www.ft.lk/article/553934/Direct-sale-of-government-securities--Demon-or-servant-), the Monetary Board which functioned under a different Governor hotly disputed this writer even to the extent of making personal remarks. 

In a statement, the Monetary Board said: “Wijewardena, during his tenure as Deputy Governor, introduced the so called private/direct placement window for issuance of government securities in 2008 by justifying it to the Monetary Board in view of circumstances of unwarranted increase in interest rates on government securities prevailing at that time.” 

This was a gross misrepresentation of the facts since direct placements were started not in 2008 but in 1997 when the primary dealer system was introduced. Hence, it is heartening that the CB annual report for 2016 has put the record straight even at this last stage. 

Realistic medium-term growth projection

The medium-term growth prospects have been revised downward to a more realistic projection by the bank in the annual report for 2016. Even as late as January 2017, the bank had entertained the high hope of the economy bouncing back to the preferred growth of 7% by 2018. This was quite contrary to what the IMF and ADB had projected for the country. Now in the annual report for 2016, which has been prepared in March 2017, the bank has made a slower recovery projection for the country in which the 7% growth target has been postponed to 2020. This will not happen automatically but through explicit corrective action to be introduced by the Government without delay. A set of such policy measures has also been recommended in the annual report for 2016.

Policies that are needed

The report has emphasised that the attainment of the medium-term growth path is contingent on addressing the deep-rooted structural issues that has prevented the country from making headway in the growth fronts in the past. It has said that both monetary policy and fiscal policy should work hand-in-hand in a supportive manner to attain this goal.

Poor performance of export sector 

Sri Lanka’s exports have been performing poorly since around 2005 and the blame had always been placed on the sluggish demand for them from foreigners. While not discounting this also as a reason, this year’s annual report has drawn attention to the failure of the country to convert its export industry from simple technology to complex technology. This was a point made by this writer in a number of previous articles in this series which was not taken into account by the authorities concerned. The annual report for 2016 has the following remark to make: “Producing more complex, high value added and more technologically intensive products, while integrating with regional and global production networks would act as a catalyst in Sri Lanka’s transition toward becoming an export oriented economy.” 

Get FDIs and join global supply chains

The key to this strategy is getting FDIs of worth and joining the global value chains. This has been further elaborated in a long box article under the title ‘National Strategy towards Export Promotions’ from pages 155 to 159. Having highlighted the outperformance of Sri Lanka by neighbouring countries, the box article has focussed on areas where immediate attention should be paid by the country. 

A realistic exchange rate is a must

They include the need for adopting a proper exchange rate policy in which the real effective exchange rate is maintained at a stable level over the years by allowing the currency to depreciate according to changes in the country’s inflation rate over that of trading partners. 

Then, maintaining the inflation rate at the proper level will depend on adopting appropriate monetary policy by the Central Bank and a budget that is sustainable in the long run by the Minister of Finance. This calls for close collaboration, cooperation and joint complementary action by both the Ministry of Finance and the Central Bank. 

Finance Minister’s public outbursts need to be restrained

This is where it is evident, according to public outbursts by the Minister of Finance, that there is a major policy dispute between the Central Bank and the Ministry of Finance. It is absolutely necessary for the Prime Minister, who is now in charge of the whole economic policy of the government as well as the Central Bank, to see that such unproductive public outbursts do not take place. They may be pleasing to the local voter base but would not be taken kindly by the international community to which it matters.

R&D should be followed by entrepreneurial innovations 

The other policies suggested are the need for continuing with a liberalised foreign policy to facilitate trade, allowing greater trade openness to enable export growth and diversification of the product mix, improvements in logistics such as development of export hubs and infrastructure, promoting research and development and innovation, and attracting worthy FDIs to get technology as well as a place in the global supply chain. 

These policies are prerequisites for Sri Lanka to attain a high economic growth on a continuous basis and should not be ignored by the Government.

On balance, the annual report of the Central Bank for 2016 is instructional to the Government especially to the Minister of Finance. Since it is written in technical language, it may be useful if it is explained para by para in simple language to all Parliamentarians. 

(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected]).