The tale of two central banks: Two different medicines to cure one illness

Monday, 15 July 2013 00:54 - - {{hitsCtrl.values.hits}}

Indonesia tightens its monetary policy Reports from Indonesia say that the country’s central bank, Bank Indonesia, has increased its interest rates by half a percent, the second such increase it has made within one month. Previously in June this year, it raised its interest rates by a quarter of one percent. Though the market had expected Bank Indonesia to make this move in July, it had not anticipated an increase of this magnitude since the normal increases in interest rates in the past have been only by notches of a quarter percent on each occasion. Hence, the high quantum of increase this time signifies the high importance which Bank Indonesia has assigned to the current problem faced by the country. These types of interest rate increases by central banks are known in the markets as ‘quantitative tightening’ since they seek to reduce the increases in the quantity of money. The continued quantitative tightening by Bank Indonesia in this manner has been prompted by two considerations. High interest rates to prevent inflation becoming permanent The first is to tame the initial increase in the cost of living of people brought about by a massive increase in the retail prices of petroleum products by the government earlier in June. Though Indonesia has been a petroleum producing country, the retail prices of all petroleum products had been subsidised by the government by selling them below costs. Since this subsidy was no longer affordable, in June, the price of petrol was increased by 44% and that of diesel by 22%. This has caused the consumer price index to jump to 5.9% in its annual growth as at June thereby exceeding the government’s inflation target of 3 to 5.5% set for 2013. Since the mandate of the Indonesia’s central bank is to maintain inflation at the targeted level and it cannot come out with excuses later if it has failed to do so, it has taken tough action to tighten the quantity of money being produced in the country. Raise interest rates to prevent the currency from depreciating The second reason was the need for arresting the pressure on the rupiah to depreciate in the market after the market was panicked by the possibility of an abrupt curtailment of the ‘stimulus package’ presently being implemented in USA. This stimulus package introduced five years ago has lowered the US interest rates artificially close to zero percent, prompting US funds to move their investments out of the country in search of higher rates of interest elsewhere. Indonesia, like Sri Lanka, has been one such country which had received a large amount of these hot funds enabling it to maintain an artificially appreciated exchange rate and live through its balance of payments problems temporarily. With news that the US Federal Reserve System will curtail these stimulus packages in the immediate future, the markets got panicked and there was a reversal of the movement of funds back to USA hoping that US interest rates too will rise accordingly. Though Ben Bernanke, Chairman of the Federal Reserve Bank, had assured last week that there was no such intention, the markets do not appear to have bought his assurances. Thus, Indonesian rupiah, like the Sri Lanka rupee, came under pressure for depreciation in the market. The increase in interest rates by Bank Indonesia was to discourage the movement of funds out of the country and thereby take the pressure out of the rupiah. Sri Lanka relaxes monetary policy Meanwhile, Sri Lanka’s Central Bank has adopted a policy which is known in markets as ‘quantitative easing’ because it seeks to increase the quantity of money in the hands of people. In May, it cut its interest rates by half a percent in order to force lending banks too to cut their lending rates in a similar fashion. This was done against the advice of IMF that Sri Lanka should not ease its monetary policy until the elevated inflation in the country in the recent past has been truly caged in. Choosing wrong interest rate to tame bankers When lending banks did not follow the central bank’s advice, the Bank threatened that it will go for even fixing ceilings on lending rates, a measure which the Central Banks had not considered for adoption in the whole of its existence since 1950, despite it has powers to do so in terms of law. In June, the Bank selected a wrong interest rate to direct commercial banks to cut their lending rates. That was the interest rate charged on the credit cardholders if they fail to pay their credit card balances within the interest-free period of one month. This interest rate had been fixed by banks at 28%, seemingly prohibitive but with a purpose. That was to discourage credit cardholders to delay payments by more than one month which the Central Bank would have welcomed because it would have helped lending banks to keep the unpaid credit card balances at a low level. The accumulation of a large unpaid credit card balance in the system, just like in South Korea in 2007, would have threatened the stability of Sri Lanka’s financial system which the Central Bank has been mandated to maintain under the law. Hence, the reduction of unpaid credit card balances to a low level through a prohibitive interest rate would have supported the Central Bank’s regulatory mechanism to maintain the stability of the financial system which is known as ‘macroprudential financial regulatory policies’. Despite this, the Central Bank having found fault with lending banks for having a prohibitive interest rate on delayed payment of credit card balances directed them in June to cut the rate by 4 percentage points to 24%. This is an instance where the action of the Central Bank has vitiated its own policy objectives. Flooding banks with money to create new money In July, the Bank went one step further toward ‘quantitative easing’. This was done by cutting the statutory reserve ratio by 2 percentage points so that commercial banks have to maintain a mandatory deposit with the Central Bank equivalent to only 6% of their deposit liabilities. Statutory reserves are meant to control the commercial banks’ ability to create new money simply by making book entries and therefore, when the ratio is increased by the central bank, their new money creation is also curtailed, a sort of quantitative tightening. Hence, when the Central Bank cut this ratio in July by 2 percentage points, commercial banks got a new impetus to create more new money; hence, it amounted to a quantitative easing. According to market estimates, this quantitative easing has released an estimated amount between Rs. 35 to 40 billion back to commercial banks to create new money in the magnitude of some 250 to 300 billion within the next 12 to 18 month period. Given the present production constraints within the country, this will mean that Sri Lanka will have to face both high inflation and high trade deficits in the future. Both will put further pressure on the Rupee to depreciate in the market. Similar macroeconomic conditions in Indonesia and Sri Lanka The monetary policy package adopted by Indonesia and Sri Lanka has been diametrically opposed though both countries have been facing similar macroeconomic problems. In both countries, there has been a massive adjustment to some administratively controlled prices, electricity tariff in Sri Lanka and petroleum prices in Indonesia. Though these adjustments have been massive, they have not been high enough in both countries to eliminate the full subsidy involved; hence, a further round of price adjustment is called for if they are interested in bringing the macro-economy to a balanced position. In the case of Sri Lanka, a separate price adjustment is needed to eliminate the losses in the country’s state owned petroleum distributing corporation, namely, Ceylon Petroleum Corporation or CPC. The Government has been postponing this price adjustment possibly in fear of a public uprising but it has compounded the problem beyond redemption today. As per the data published in the Annual Report of the Ministry of Finance and Planning, the operating losses of the CPC in just 2011 and 2012 have been close to Rs. 200 billion and even an increase of petroleum prices by 100% will not be sufficient to eliminate these losses. According to the data published in the Central Bank Annual Report 2012, six major public corporations have made operational losses amounting to Rs 185 billion in 2012. What does it mean? It means that the tax payers will have to bear the burden of these losses either by way of higher taxes if the Government proposes to meet them through the issue of Government bonds which the Treasury had done in the past or the general public to accept higher inflation if these losses are to be met by printing of new money through the Central Bank. Hence, Sri Lanka’s macroeconomic fundamentals are not at all strong as claimed by some authorities in the country. Rising inflation leads to currency depreciation In both Indonesia and Sri Lanka, inflationary pressures are rising after the increase in the administratively controlled prices. In Indonesia’s case, the consumer price index has increased to 5.9% after the adjustment of the petroleum prices, and in Sri Lanka, it has risen above 6%. Though controlling a price index should not be the target of a central bank’s monetary policy but maintaining equilibrium in the macro-economy, these increases portend an ominous development for the future of the country. Both countries have a substantial deficit in the respective current account of the balance of payments and therefore have to rely on inflows of foreign exchange to meet the foreign currency shortages. This has been made by attracting short term hot money as investments. Hence, when the markets get panicked about a possible termination of the stimulus packages in USA which is a reality pretty soon since USA cannot afford to go on these free policies for long, the respective currencies will come under pressure for depreciation. This has been the reality in both Sri Lanka and Indonesia in the recent few weeks. One illness and two medicines Thus, the macroeconomic problems faced by both Sri Lanka and Indonesia are the same but they have adopted diametrically opposed policies to arrest the situation. But how can these opposing positions be justified on economic grounds? Has the subject of economics become theoretically freakish to support two opposing curative treatments for the same illness? Or has economics become irrelevant in tackling world’s problems? To answer these questions, it is necessary to examine why Indonesia did what it did and why Sri Lanka has done what it has done. Don’t increase money supply when costs have pushed the prices up The increase in the cost of living indices due to increases in the costs of important inputs is known as ‘cost-push inflation’, somewhat a misnomer to describe inflation. This is because inflation is an increase in the general price level over a long period of time whereas increases in costs of inputs are only a one time phenomenon. Hence, when important input costs increase, they invariably increase the cost of living index making living a burdensome activity to consumers. It becomes long term inflation only if the central bank of the country causes money supply also to increase through a relaxed monetary policy package. Economists call this ‘accommodating the increases in the cost of living indices’. This is because if the central bank does not increase money supply through relaxed monetary policy, the economy is supposed to get adjusted to the new costs through an improvement in productivity. That improvement in productivity is supposed to reduce costs and negate the original increase in the cost of living index. However, this process is interrupted if the central bank adopts a relaxed monetary policy because it will increase the total demand and causes the prices to increase further and continuously. Thus, the culprit in a continuous inflation in a country is the central bank of the country which has simply accommodated the cost increases through a relaxed monetary policy. This is the reason for Indonesia to tighten monetary policy when there were increases in the cost of living index due to increases in the prices of petroleum products. Sri Lanka’s faith in money’s ability to create wealth But against this situation, Sri Lanka has relaxed its monetary policy. Why has Sri Lanka done so? According to Central Bank’s press release, the Bank has reduced its interest rates in May “to stimulate the domestic economy, particularly in the light of the gradual moderation in headline inflation and subdued demand pressures in the economy.” Since this did not generate the required results, the Bank had to continue with further rounds of relaxing monetary policy of the country. When the Central Bank of Sri Lanka did this, it had made a very important assumption. That assumption is that when it provides money into the hands of people, that money makes everyone feel richer through the activation of an effect which economists call the ‘wealth effect’. Then, the Central Bank supposes that it leads to higher consumption and higher investment supporting the economy to produce more output and wealth. Stimulate the economy and reap inflation and rupee depreciation But in an open economy like Sri Lanka, when people increase their consumption, it leads to consume not the locally produced goods but imported goods. Thus, central bank sponsored money supply growth will simply lead to increase the demand for imported goods thereby generating problems for the country’s balance of payments and the stability in the exchange rate. When the balance of payments gets into a deficit, a country has to draw on its foreign exchange reserves to fill the gap. When a country loses all its foreign reserves to finance its balance of payments deficit, it comes to a situation where it will not be able to support the existing exchange rates. With no more foreign reserves available, the country will be forced to allow its currency to go for a free-fall against other currencies. This is what happened to Sri Lanka in 2000, 2009 and again in 2011.

Thus, the relaxation of the monetary policy to stimulate an economy in a background of cost increases is a sure way to invite inflation in the future. It then drives the country’s exchange rate down causing the rate to go through a massive depreciation. This is what Indonesia is trying to avoid by tightening its monetary policy. Since Sri Lanka is doing the opposite, whether the country would be able to stimulate the economy without causing inflation and depreciation of the exchange rate is yet to be seen. (W.A Wijewardena can be reached at [email protected] )

The tale of two central banks: Two different medicines to cure one illness

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