Central Bank Must be Independent to Save the Economy
Posted on March 18th, 2023

Dilrook Kannangara

Even a schoolkid who has studied Year 11 Commerce would tell you that the Central Bank must be independent of the government. And that’s how it is around the world. However, Sri Lanka does not follow the rest of the world. Well established norms are questioned, challenged and changed in Sri Lanka to suit politicians and their supporters. What is even more convincing is Independent Ceylon (1948 to 1972) and Sri Lanka (1972 to 1978) had an independent Central Bank.   

Historical Independence of CBSL and Economic Stability

Sri Lanka had a great tradition of Central Bank independence until 1978. Its remnants held some traditional value of independence until 2006. As a result, politicians could not indebt the nation (all government long term debt is either taken by the Central Bank or the Central Bank guarantees debt) beyond repayment capacity. Thanks to CBSL independence, the loan profile of the country was managed well; politicians could not borrow as they pleased; money printing was restricted to currency requirement which was tied to economic growth, and reserves of the CBSL were very healthy and were protected from looting, misappropriation and fraud.

Until 1972 Central Bank’s independence was guaranteed by the law as there was no one in a government post who could interfere with the CBSL. There was no executive president then. Sadly things changed since 1978 with the creation of executive presidency. The executive president could interfere with anything. Fortunately, no executive president interfered with the CBSL until 2006 recognizing the need to keep it independent.

The economy was stable. Just two years had negative economic growth rates but bounced back immediately. International lenders and trade creditors trusted the CBSL (as it was independent from the government) and credit ratings held their ground at acceptable levels.

Interference Since 2007 and ISB Debt Trap

Unfortunately, CBSL independence ended in 2006. Politicians appointed another politician to the top post who did not rise through the ranks. A Central Banker who has risen through the ranks would be skilled appropriately to manage it. A top business executive without political affiliation would fair reasonably in the post. However, in 2006 the appointee contested the 1999 provincial council election and was elected and he also contested parliamentary elections thereafter.

No surprise that Sri Lanka issued its first ISB (International Sovereign Bond) in 2007 for $500 million. The decision was taken by the government but the CBSL did not have independence to say no. It was a modest amount (though five times that of the Lotus Tower) but it was the first time Sri Lanka went for market borrowings. Previously the CBSL was not interested in foreign market borrowings as they are extremely costly (high and variable interest rates), they must be repaid within 5 years in US dollars, no grace period and no accountability over where it is invested. Thus started Sri Lanka’s loan death trap. Started small but as expected it snowballed out of control. By now about 50% of Sri Lanka’s foreign debt is ISBs.

Further Interference and Hedging

While ISB foreign loans snowballed, lack of CBSL independence led to other undesirables too. State corporations were not only allowed to borrow directly (bypassing CBSL) from foreign loan creditors, they were also allowed to enter in to speculative hedging deals with commercial banks. CBSL never allowed it before but as it lost its independence, it could only be a helpless spectator of this economic calamity. However, the CBSL was compelled to guarantee foreign loans taken directly by corporations. This bankrupted these corporations too as they had no foreign currency earnings. (This was the reason they were not allowed to borrow directly until 2011).

This move achieved a political outcome. Direct foreign borrowings of $9.5 billion by state corporations was kept out of CBSL books. The government boasted a lower than actual foreign loan figure just to hoodwink the public. As a result, even most economists were unable to forecast the impending debt and economic crisis as they traditionally based their analyses only on CBSL annual reports.

Sri Lanka started suffering credit rating downgrades as the CBSL was not guaranteed independence.

CBSL Gold Reserves, Greek Bonds and 2015 Bond Fraud

Other effects of lack of independence were seen in the mismanagement of the nation’s foreign reserves and CBSL gold reserves. Instead of growing these, lack of central bank independence meant they were depleted without replenishment to meet the requirements of politicians and their various visions” (Chinthanaya”). An Independent CBSL would not stand in the way of these visions” just to disrupt them. However, an Independent CBSL would not deplete its reserves and would advise the government how to retain the reserves and implement those plans (or the economic reasons for not implementing those plans). Therefore, any action that depletes national reserves would be blocked by an independent CBSL. Sadly, Sri Lanka was denied this protection due to the absence of a law ensuring independence.

Another first for the CBSL happened during this time. Greece was going through economic turmoil and as a EU member it was widely expected to be bailed out by the EU. Some speculative investors bought Greek bonds cheaply hoping they would fetch higher values after the bail out. However, EU’s austerity measures did not allow anyone to profit at Greece’s expense and those who bought them suffered huge losses. An independent CBSL would never have invested in speculative ventures.

In 2015 the CBSL issued local rupee bonds as it does. But this time it was traded by the son-in-law of the CBSL Governor. Interest paid to these bonds were artificially raised to make the trade profitable for the largest buyer! As a result, interest rates across the banking system went up. Cost of capital (which is an addition to CBSL base rates) naturally went up bankrupting many a business venture.

Further Interference and Bankruptcy

Interference continued as years passed. Politicians blamed the CBSL for not using their tools to extend loans to people. Due to the absence of independence, CBSL was forced to do as instructed. It was also instructed to print currency notes recklessly and to repay ISB loans in 2021 and 2022 when it was obvious such payments would permanently deplete basic reserves any nation must maintain.

As a direct result of these moves, Sri Lanka declared it was unable to repay foreign loans on April 12, 2022. Sri Lanka’s inflation went to unprecedent heights and stayed amongst the worse in the world. Economic growth rate went negative for 3 years which is a world record not just a Sri Lankan record.

People Pay CBSL Salaries to Serve Them, Not Politicians

CBSL must be independent. It owes it to the people who pay their salaries. People benefited when the CBSL was independent and suffered due to lack of it. No one wants a central bank independent from the people which is not possible. What is needed is a central bank independent of politicians. Politicians’ claim that the central bank would be another independent state if it were granted independence is absurd. It has not happened in any country and not in Sri Lanka either before 1978. CBSL salaries are paid by the people and not by politicians so politicians have no right to have anything to do with the central bank. Central Bank policy is the same across the world – economic development and stability through effective monetary policy management. That’s all an independent central bank would do. And that’s exactly what a central bank would be unable to do if it is not given independence. The government should manage the fiscal policy which can follow a political vision to the extent it does not clash with the monetary policy. For ease of understanding, it is like managing money in a household. Money can be spent on needs, wants and dreams but only to the extent the household has (or can reasonably repay if borrowed). No one can spend money to pursue their dreams if it bankrupts the household. That includes genuine desires, gambling and even charity if they cannot be afforded by the household. In a functioning household these will be conservatively managed by the mother who is conscious of future money needs and is not concerned about being popular with the children when it comes to money matters.

Today the stakes are even higher. Sri Lanka is at the mercy of international lenders (IMF, loan creditors and trade creditors), and rating agencies. They only accept an independent central bank. If they don’t come to the party, Sri Lanka collapses. There are no more free lunches.

Sri Lanka is at a crossroads – legally enact and ensure central bank independence and overcome the many economic crises it is in or plunge deeper into manifold crises.

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