"RBI had become like a cookie jar, where the government, as and when they wanted, could just dip into the cookie jar and take what they wanted," says Narendra Jadhav, Principal Advisor and Chief Economist of the Reserve Bank of India.
"But in 1993, there was a contract signed between RBI and the Ministry of Finance, which paved the way for the elimination of this automatic monetization. Over a 4 year period we eliminated the automatic monetization of the deficit."
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"RBI had become like a cookie jar, where the government, as and when they wanted, could just dip into the cookie jar and take what they wanted" - Narendra Jadhav, Principal Advisor and Chief Economist of the Reserve Bank of India. |
Using central bank credit or 'printed money' to bridge the budget deficit creates inflation by artificially driving money supply beyond the productive capacity in the economy.
In 2004, the Central Bank of Sri Lanka had to print 65 bn rupees (US $ 650 mn), largely to finance political subsidies, by purchasing treasury bills from the government.
As a result, inflation rocketed from almost zero to 18 percent in just eight months, while a balance of payments crisis also developed in tandem, as the printed was mostly used to subsidize imported commodities like fuel and fertilizer.
Freedom to print
Before independence most colonies had currency boards, which are not true central banks. As a result, colonial administrations could not print money.
But after independence, central banks were set up giving power to the newly independent rulers of former colonies to print money and maintain their popularity.
The Reserve Bank of Zimbabwe now prints so much money that year-on-year inflation in December 2005 was 540%.
The Zimbabwe dollar, which was 5,735 to the US dollar in January 2004, is now 99,200 to the US dollar.
Singapore is one of the few countries, which deliberately refrained from the temptation of dipping into the 'cookie jar' by not establishing a true central bank.
Though India set a limit of Rs 500 mn, or 50 crore, for central bank credit, a way was soon found to breach the prudential limit, and print money for political expediency.
"They said, if the amount is likely to go down below 50 crore, then RBI should issue itself an IOU which was called an ad hoc treasury bill," said Jadhav.
"But what started like a trickle became a flood."
Between 1955 and 1991 (India was hit with a balance of payments crisis in 1991), a total of Rs 108,000 crores of ad hoc treasury bills had been issued, says Jadhav.
Britain went off the gold standard after the government printed too much money to finance World War I, and the resultant inflation increased the gap between the market price of gold, and sterling to unsustainable levels.
The US dollar went through a similar crisis sometime later.
After World War II, the US Federal Reserve Bank signed an accord with the Treasury to stop printing money.
This agreement, which was signed in March 1951, paved the way for the Fed to conduct independent monetary policy.
Ironically, Sri Lanka's central bank was also set up in 1951, with the help of a US Federal Reserve expert, John Exter.
But under subsequent post-independent governments, budget deficits have got larger, inflation has made most people poor, concentrated wealth among asset owning classes, and chronic currency depreciation has become the accepted norm.
In Sri Lanka where the treasury secretary is automatically represented in the monetary board, the worst money printing was seen in the early 80's, when large amounts of debt was monetized to provide counterparty funds for capital projects.
Waiting for sense
Though India has stopped dipping into the cookie and creating inflation, Sri Lanka's central bank remains a major creditor of the government even to this day.
The Central Bank does this in two ways; by purchasing treasury bills in the primary market, and by extending a part of the projected revenue in the budget, as a provisional advance at the beginning of every year.
By the time the tsunami hit the country; the Central Bank has printed or extended credit to the government to the tune of Rs 108 billion.
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Bad Money - Central Bank credit to government. |
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Nov 2003 |
Rs. 42.8 bn |
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Dec 2004 |
Rs. 108.1 bn |
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Nov 2005 |
Rs. 76.6 bn |
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Source: Central Bank |
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A central bank can refuse to print money in the face of weak fiscal policy (large deficits) by staying off the primary treasury bills auctions and allowing rates to go high enough to persuade the public to part with their money.
But when interest rates go up, businesses are hurt and the economy slows down. The interest cost of the treasury also rises.
Fiscal dominance
To avoid these effects a treasury of a developing country will usually put pressure on the rate-setting monetary board of the central bank not to raise rates, and instead print money and buy treasury bills with 'printed' money.
This is what economists call 'fiscal dominance' of monetary policy.
When this happens inflation will rise and if sufficient T-bills are bought by the central bank, a balance of payments crisis will follow.
Another side effect is that the public and market participants will lose faith in the central bank's willingness and ability to control inflation.
This can fuel inflationary expectations and drive prices and wages up even faster.
But the RBI had been able to establish credibility after it gained independence from the treasury.
"What happened was, gradually monetary policy disentangled itself from the fiscal policy and came in to its own," said Jadhav.
"That is why monetary policy became more credible."
Precious commodity
Jadhav says central bank independence would not just be given on a platter: It has to be fought for, and maintained.
"I think Independence is something that is never something that is given. Independence is something you have to achieve. You have to snatch it if it is not coming. And once you get that I think you have to meticulously maintain that."
In Sri Lanka the law governing the central bank was changed, to make maintaining price stability (keeping inflation down) the main objective. But there are no other safeguards to prevent the central bank from igniting inflation like it did in 2004, except the will of the members of the monetary board.
"It is so easy in our part of the world to give up independence," observes Jadhav.
"It is very tempting. For the short-term gain of your own position you may be prepared to surrender the institute's achievements in terms of independence. This of course is something that depends on the character of the governor and the top management."
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It is so easy in our part of the world to give up independence. For the short-term gain of your own position you may be prepared to surrender the institute's achievements in terms of independence. This of course is something that depends on the character of the governor and the top management. - Naredran Jadhav, Principal Advisor and Chief Economist of the Reserve Bank of India |
The governor of Sri Lanka's central bank Sunil Mendis, and some top officials had come under repeated fire from members of the Janatha Vimukthi Peramuna, a Marxist-nationalist party supporting the ruling coalition, that is also the driving force behind weak fiscal policies.
When the rupee depreciated in 2004, the party accused the central bank officials of depreciating the currency, though the bank spent hundreds of millions in a vain attempt to defend the currency, while the printing binge drove interest rates down.
Recently the party also accused the Central Bank of bringing the government to disrepute when it learned of plans to introduce a two-thousand-rupee bank note, which is twice the value of the largest existing denomination.
-Asantha Sirimanne: asantha@vanguardlk.com
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