The Way Forward: Price stability and prosperity need good governance: Part 1

Dr. Sharmini Coorey 

The following are excerpts of the oration delivered by Dr. Sharmini Coorey, Advisor to President Ranil Wickremesinghe and former Director at IMF at the 73rd Anniversary of the Central Bank of Sri Lanka last week

Good afternoon, ladies and gentlemen. First, I would like to thank Governor Weerasinghe for inviting me to deliver the 73rd Anniversary Oration of the Central Bank of Sri Lanka. I am honoured to address such a distinguished audience of leaders and members of the policymaking and financial community. I would also like to recognise the talented and hardworking staff of the CBSL who have had a very challenging year and a half, if not longer. 

Let me start by congratulating the Governor, Deputy Governors, members of the former Monetary Board and members of the current Monetary Policy Board. Since April 2022 they have taken bold decisions and led the demanding technical work to stabilise the economy after the deepest economic crisis that Sri Lanka suffered since independence. It is easy perhaps to take for granted the progress so far. But let us not forget that barely 20 months ago, Sri Lanka’s inflation rate was unanchored, the exchange rate was depreciating uncontrollably, foreign reserves were depleted, and the economy was collapsing with shortages of food, fuel, and essential medicine. Declaring an orderly foreign currency debt moratorium, raising interest rates sharply, and curtailing the monetisation of fiscal deficits were essential first steps to stabilise the economy and avoid a disorderly default.  It is no mean feat to have brought inflation down from a peak of almost 74 % last September to less than 2 % a year later, over-performing the IMF’s projections. To have accomplished this while maintaining financial stability is all the more impressive given the deep economic contraction that, together with the preceding pandemic, has weakened financial sector balance sheets. Monetary policy was also responsive in lowering the policy rate when clear evidence emerged that monthly inflation was stabilising. Let me say, based on my years of experience at the IMF working with countries around the world, often during economic stress that these are by any standard impressive accomplishments. Without skilled leadership and decision-making, it could easily have been much worse. 

These monetary policy actions were successful also because of the support from the Government’s fiscal policies and the leeway given to the CBSL to conduct monetary policy according to its best judgment. Tax cuts during the previous Government had reduced our tax ratio from almost 11% of GDP in 2019 to a mere 7.5 %,on average in 2020-21, one of the lowest in the world, lower even than the tax ratios of very poor countries like the Central African Republic and Burkina Faso. With interest payments taking up 73 % of government revenue and an overall fiscal deficit of almost 12 % of GDP on average in 2020-21, the fiscal position was simply not sustainable. The Government took decisive and necessary action to increase tax rates, bolster tax collections, and implement cost-recovery pricing in energy. It has tightened spending to generate the needed improvement in the primary fiscal balance in line with the IMF-supported program. These were difficult decisions and politically unpopular. But they were necessary.

Unfortunately, the ship that is the national economy cannot be turned around quickly. So people tend to blame the corrective policies and the policymakers who are doing the right thing, rather than the reckless policies of the past that are the fundamental cause. Such is the unenviable position of policymakers who step in to rescue their countries from crises. 

Now, significant progress has been achieved but we are in a low-level equilibrium with output well below potential. This crisis is not yet over. The only way out is to grow, at a rate of about 5-6 % a year, in a sustainable inclusive way. Without such growth, we cannot escape our high debt burden even after a successful restructuring. And because the debt burden lies with the public sector, the latter would need to contract not just this year, but also in the decade ahead. So growth will need to come from the private sector and be export-oriented given our foreign exchange needs. There is simply no other option.

Much remains to be done. We should not take for granted, having achieved low inflation, that inflation would always stay within the CBSL’s target of 5 % or that progress in the fiscal area will continue. Our post-independence economic history is full of stop-and-go policies and brief victories over instability that are not sustained. We cannot afford yet another replay of that familiar script.

This time really is different

Well, this time really is different, for three reasons:

First, in all our previous bouts of macroeconomic instability, our public debt ratios have stayed below 80 % of GDP, tax revenues have never been as low as they were in 2020-21 and we had never defaulted on our debt. According to the IMF’s Debt Sustainability Analysis, even if we successfully restructure our debt and adhere to tight policies that generate primary fiscal surpluses of 2.3 %of GDP from 2025 to at least 2032, our public debt would decline to only about 95 % of GDP by 2032. To put this debt level in perspective, in 2022, government debt to GDP averaged 65 % in emerging and developing economies and, looking at our neighbours, 55 % in India; 40 % in Indonesia; and 54 % in Thailand. So unlike in the past where we muddled through with debt to GDP ratios around 60-80 %, the baseline debt ratio will now be much higher. We will be at a high risk of debt distress even after a successful debt restructuring. If we become complacent and go slow on reforms, we can easily be back in a crisis where we are unable to pay our debts. Except next time, the adjustment would be far more painful because we would have already restructured domestic and external debt. More of the adjustment therefore will fall on our citizens and less on external creditors. This point needs to be widely understood.

 The second reason is that many people are now in poverty or very close to poverty and have little or no cushion left. The World Bank estimates that the poverty rate doubled to 25 % of the population in 2022 while the UNDP estimates that over half the population remains “multi-dimensionally vulnerable.” The World Food Program finds that almost a third of children under 5 are malnourished with 20 % suffering from wasting. Nearly two-thirds of the population are borrowing or dipping into their savings to feed their families. Many people are foregoing basic needs such as healthcare, and progress in education has been severely hampered by both the pandemic and the economic crisis. The impact on people of another debt default, crisis, and adjustment would be disastrous and raises the likelihood of social unrest.

Third, Sri Lanka is suffering from a damaging outflow of skilled professionals who are the backbone of economic recovery and growth. These professionals are not leaving merely because of taxes as is often said. They have lost hope that the poor governance and pervasive corruption that Sri Lanka has been mired in for decades would be effectively addressed. They don’t see a future in a country where the state interferes with practically every aspect of economic life, and politicians and public officials who engage in gross corruption are never punished. Another crisis will turn this outflow into an exodus.

The empirical evidence clearly shows that crises cause permanent losses, both in terms of GDP and human welfare. Countries that undergo multiple crises, like Argentina, stagnate compared with countries that have steady growth over prolonged periods. Boom-bust cycles leave countries worse off. We should not try to get out of our current low-level equilibrium through fiscal policies that give a short-term boost but land us in another debt crisis a few years down the road. We will also be vulnerable for many years to exogenous shocks, such as a rise in global food and energy prices, particularly, from ongoing wars in Ukraine and the Middle East; higher world interest rates; a poor agricultural harvest; or a natural disaster. In addition, we need to invest considerable resources in adapting to climate change and preserving biodiversity. We are on a knife edge, and there is simply no room for slacking off or policy reversals. But, with focus and effort, we can set ourselves on a road to sustained growth and inclusive prosperity.

So what is the way forward? How can we avoid repeating our history of inconsistent, stop-and-go policy making? We have discussed for years what is needed for sustained growth, fiscal discipline, an open trade regime that encourages exports, competitive markets, modernised labour laws, adequate infrastructure such as efficient electricity, transport, and ports. It’s no mystery, so why don’t these things get done?

I believe, our fundamental problem is poor governance and that, unless we address governance problems head on, we would never durably overcome our economic problems and prosper. My thesis today is that when we discuss economic policies, we should focus more squarely on the governance around those policies and not only on the policies themselves.

What is good governance

So what do we mean by “good governance”?

There is no standard definition, but people know bad governance when they see it. Certainly, not a day goes by in Sri Lanka without the newspapers reporting some instance of bad governance.

Let me use the definition by UNESCAP. They define governance as [quote] “the process of decision-making and the process by which decisions are implemented”. The principles of good governance include accountability, transparency, adherence to the rule of law, responsiveness, effectiveness, and efficiency. 

We need to be more explicit not just about economic policies, for instance, whether an interest rate or a tax rate should be raised or lowered or a particular public enterprise privatised or not. We also need to be explicit about the process by which those policies are decided and implemented. It is very likely that if we improve the process, i.e. we make policymaking and implementation more accountable, transparent, adhere to the rule of law, the resulting policies would improve as well. It is also likely, if we have good policymaking processes and strong institutions, good policies will continue even if the politics turn difficult.

I do want to acknowledge that getting to good governance is no simple task. It requires sustained social pressure and political will to take on the vested interests that are served by poor governance. People sometimes complain that nothing works in Sri Lanka. That’s not quite true. Actually, things work very well, for a small group of people. The challenge, if we are to avoid repeating the mistakes of the past, is to ensure that our policymaking and implementation processes and institutions obey the principles of good governance so that policies serve the interests not just of a small group, but of all members of society.

I would like to focus today on the good governance for three policy objectives that are, in my view, the most important to get us out of this crisis and lay the basis for inclusive prosperity. 

 First, maintaining durable price stability through sound monetary policy

 Second, achieving fiscal sustainability through better taxation

 Third, enabling market-oriented growth by reducing the size and role of the public sector

For the last two, mainly fiscal topics, I draw extensively on three sources published in September: the IMF’s Governance Diagnostic Assessment of Sri Lanka, (GDA); Sri Lanka Civil Society’s Governance Diagnostic Report; and the World Bank’s Country Update on Sri Lanka. These reports are based on thorough research; extensive interviews with officials and other stakeholders; and written or guided by experts with international experience in their respective fields.

Since this occasion marks the 73rd anniversary of the CBSL, let me start with strengthening the governance to maintain durable price stability through sound monetary policy.

The economics literature and central banking practice have convincingly established for decades the need for Central Bank independence and a sound monetary policy decision-making process to achieve low and stable inflation. Most major countries’ laws safeguard central bank independence and aim to insulate monetary policy from political interference. Indeed, one of the oldest such laws, the U.S. Federal Reserve Act of 1913 recognises this need explicitly. It specifies, to that end, that the Federal Reserve may buy and sell US Treasury securities only in the “open” or secondary market. It was recognised then, over a hundred years ago, as it is now, that direct financing of the government would leave decisions over monetary policy open to political interference and undermine the goal of low inflation while creating risks to economic and financial stability.

Need for Central Bank independence

This year’s passage of the Central Bank of Sri Lanka Act is a very significant milestone on the path to achieving good governance in the conduct of monetary policy. The Act explicitly recognises the CBSL’s independence. There is now a clear mandate that price stability is the primary objective of the CBSL with financial stability as a secondary objective. Inflation-targeting with a flexible exchange rate is established as the monetary policy regime. A critical feature is that there are no longer any government officials in the monetary policy decision making body, the Monetary Policy Board, nor on the Governing Board, which oversees everything else. There is also an appropriate balancing of CB independence with accountability and transparency. The inflation objective is specified by the Finance Minister, who would be an elected representative. The Monetary Policy Board is accountable to Parliament through the Minister to deliver on the inflation objective and provide a public explanation if inflation falls outside the agreed range for two consecutive quarters. The Board is also mandated to issue a public statement after each policy meeting to explain the monetary policy decision in the context of economic developments and forecasts. In addition, the CBSL has to issue a public inflation report every six months explaining its inflation projection and key risks to the projection. Contrary to the concerns that emerged during the parliamentary debate, these features of the law provide for much greater accountability than in the past. The operational independence that the CB has been given to achieve the target assigned to it should not be confused with being unaccountable. Quite the opposite. 

The strong legal framework is necessary, but not sufficient, condition for sound monetary policy. Legislation must be reinforced by practice and the creation of a strong culture. An important responsibility for the newly-constituted Boards, the distinguished members of which are here today, will be to create the practice and culture of good governance under the new legal framework. In particular, given Sri Lanka’s past, it will be important to ensure that the Monetary Policy Board takes policy decisions on solid technical grounds with a clear focus on the price stability mandate. The technical grounds would be based on CBSL staff’s economic modeling and analyses combined with the Board’s collective judgment on the likely evolution of inflation. Insulating the conduct of monetary policy from fiscal and political pressures would be the hallmark of a good decision-making process, especially, in the upcoming election year. This is not the only responsibility of the CBSL. Everyone, including political actors, need to create the culture of respecting the CBSL’s operational independence and the integrity of its decision-making. Central Bank independence needs to be supported by our social and political culture.

The newly independent CBSL needs to promote a culture of transparency. The new law includes key features such as post-meeting public statements, regular inflation reports, statements in anticipation of significant shocks, and answering to Parliament. While many central banks publish inflation reports and post-meeting statements, they are not all equally illuminating. Some statements are anodyne and avoid addressing substantive issues the decision-making body grappled with. Others, such as those by the Nordic central banks, the Bank of England, and the Fed inform the public about the substance of the issues the policy committee discussed. They give a sense not only of the balance of risks to inflation, but also how the committee sees the likely stance of its policy rate looking forward. Transparency is a “must have,” not simply a “nice to have,” in an inflation targeting regime. Clear explanations of how the Monetary Policy Board sees inflation risks and how its actions would keep future inflation within the target range are needed to anchor inflation expectations of financial markets and the public so that actual inflation stays within the target range. Transparent communication may initially be met with confusion and misinterpretation. But over time, both financial markets and the public will learn how the Monetary Policy Board assesses inflation risks and how it is likely to react to shocks. This will help the CBSL keep inflation within its target range even when the economy is subjected to significant shocks.

As the CBSL Law gets established and the Bank’s practices evolve, a further strengthening of the legislation could be considered to safeguard the CBSL’s independence.

 In my view, three features of the Law could be re-examined, the last of which is the most important: 

 (i) First, we need to reconsider the description of the powers, duties, and the functions of the CB. Article 7

(j) states the CBSL will [quote] “act as financial advisor and banker to the Government” while Article 7 (k) states it will “act as fiscal agent of the Government”.  Given the context in Sri Lanka where the government has relied on the CB for expertise, the reference to “financial advisor” is understandable, but not desirable. To safeguard more securely the CBSL’s independence, there needs to be a sharper line between its activities and the activities of government. Also, given Sri Lanka’s history of money-financed deficits, it is best to avoid describing the CBSL as “banker to the government”. In common understanding, a “banker” gives credit and liquidity to its clients. However, a main point of the CBSL Law is to ensure that the CBSL does neither! In my view therefore, Article 7 (j) should be eliminated altogether, and Article 7(k) amended to describe the CBSL as “fiscal agent and depository” of the government so that it can carry out normal central banking functions, such as holding government deposits and effecting payments through government accounts held at the Bank. Eliminating this reference would also help people understand that the primary function of the CB is to serve the public by protecting the value of the currency, that is the amount of goods and services they can buy with their money, which is what price stability achieves. Protecting the value of the currency shouldn’t be misunderstood to mean keeping the nominal exchange rate constant. A flexible exchange rate is essential to absorb shocks to the economy and facilitate adjustment of relative prices, the so-called real exchange rate. The focus of the CB needs to be on the price level as a whole, not just the traded component of it.

 (ii) A second strengthening given Sri Lanka’s history, is to consider ring fencing even more tightly the requirement imposed by the Supreme Court that the government should have access to direct CB financing in emergency circumstances. The CB’s job, including in emergency situations, is to provide liquidity to the market as a whole, not to the government in particular. For instance, the US Federal Reserve intervened in financial markets during the September 11 terrorist attacks in 2001, the Global Financial Crisis in 2008 and when the COVID pandemic hit in early 2020. If the government has an emergency financing need it can and should issue short-term treasury bills in the market. If the market is short of liquidity, the CB can provide liquidity to the market through various means such as reverse repo operations with the banking system and/or the Liquidity Support Facility to stabilise financial conditions. This is different from providing direct financing to the government.

(iii) Third, and most importantly, the size of the Monetary Policy Board should be reduced, in my view, to five or seven members and not include members of the Governing Board. Let me add that this has nothing to do with the current members of these Boards, all enormously qualified and distinguished. My point is about the structure of the decision-making bodies from a good governance point of view.  First, the conduct of monetary policy should be seen as a mainly technical function carried out by people with specific expertise in economics and finance. With the exception of the Governor, having the same membership across the two boards mixes this very specific function with oversight functions, which belong to the Governing Board and which require a broader range of expertise including banking, legal, accounting and audit, and risk management. Second, it is important to isolate the monetary policy decision, which affects the entire country, from the governance function which is specific to the CB. To give an example, monetary policy decisions should not be influenced, or even appear to be influenced, by how it might impact the balance sheet or profitability of the CB, which comes under the purview of the Governing Board. Third, a large monetary policy-making body dilutes the transparency and accountability that is critical for an effective inflation targeting regime. It is difficult, in my view, to hold a group as large as 11 people accountable for a policy decision. A five-member board headed by the Governor and comprising two Deputy Governors and two independent experts from outside the CB would be more nimble and cohesive. Finally, and most critically, it is highly unusual for the externally appointed members of a monetary policymaking body to outnumber members from the CB staff. In fact, I couldn’t find a single example of such a structure in a major central bank. This feature potentially opens the CBSL to political interference. A more common structure where the number of CB staff is matched by outside members allows the Governor to cast the deciding vote if there is an even split between insiders and outsiders on a monetary policy decision. It thus places a greater degree of accountability on the Governor when reporting to Parliament and the public. The current structure of the Monetary Policy Board where, other than the Governor, there are two CB staff members and as many as eight outside members is in my view problematic given that policy decisions are taken by a majority vote. A future government could exert political influence over monetary policy decisions by swamping the Board with political appointees. This, in my view, seriously threatens the independence of the CBSL and needs to be rectified.

To be continued tomorrow...