His silver hair and affable nature set him apart, but the professional challenge confronting Sri Lanka’s new Central Bank Governor Indrajit Coomaraswamy requires of him a Rajanesque response.
India’s inflation-taming, bank-reforming, currency-confidence-building central bank (Reserve Bank) Governor Raghuram Rajan had a grand track record, as an academic and the IMF’s top economist before his appointment to the job. He highlighted the risks in US bank-lending long before a mortgage crisis erupted with disastrous consequences for the world economy. Coomaraswamy – an economist who started his career at Sri Lanka’s Central Bank – has a rather more modest but nevertheless credible record.
Fawning over Coomaraswamy’s appointment in media, online and in social circles is a relief – it may dilute the damage his two predecessors did to that office, and strengthen perception of his suitability for the role.
Credibility, the currency of central banking, was in short supply under former governors Nivard Cabraal and Arjuna Mahendran. Under Cabraal, Sri Lanka went through two BOP crises: the first following the Central Bank’s high-inflation-generating money-printing to support government spending and the second when, with disastrous consequence, it maintained a peg to the greenback. Cabraal was an accountant, a business consultant and a politician, but not an economist.
This wasn’t the worse of it. Where Central Bank Governors had been discreet in their sage economic counselling of government and tactful about their dealings with other stakeholders, Cabraal adopted a megaphone strategy. The Governor’s political stance was thinly disguised and backed all government policy, completely compromising any independence or non-partisanship the Central Bank had.
[pullquote]Coomaraswamy’s professional and non-aligned track record may calm the doubters at first. But as Rajan did, Coomaraswamy must guide the bank along a difficult path to win confidence and re-establish its autonomy[/pullquote]
Macroeconomic policy will never be devoid of politics. GDP growth rates, job creation and investment all require fundamental trade-offs which monetary policy makers must appreciate. However, the Central Bank’s ability to resist monetary financing of government spending is independence worth protecting, as Governors – who also chair the Monetary Board – have done in the past.
In 2013 when Raghuram Rajan took office as Reserve Bank Governor the Indian currency was in freefall and investors doubted the economy’s longterm prospects. Rajan’s deft handling of markets gave investors confidence at a time when the administration was seen as rudderless.
Coomaraswamy’s professional and non-aligned track record may calm the doubters at first. But as Rajan did, Coomaraswamy must guide the bank along a difficult path to win confidence and re-establish its autonomy.
Inflation is creeping up. In June 2016 the National Consumer Price Index picked up 6.4% from a year ago, compared with a 5.3% increase in May the same year. If the trend continues, it will be the first test for Coomaraswamy. Central Bankers’ reputations are determined by their inflation-taming credentials more than anything else. Greater Central Bank autonomy is a phenomenon appreciated more by countries facing low growth and rising inflation pressure. In such a climate, printing money isn’t a handy alternative. Governments – unwilling to enforce the pain of tax hikes and spending cuts – look to the monetary authority for solutions. Coomaraswamy has an opportunity to demonstrate that monetary policy should be allowed greater influence during Sri Lanka’s rise to upper middle-income league.
The Central Bank and its Monetary Board also manage the government’s debt office and private sector retirement funds in the Employee Provident Fund (EPF). These agency functions are in conflict with monetary policy setting, first, because of the government requirement to minimize its borrowing cost and second, because future retirees will want to maximize their returns on savings. Both of these are at odds with the bank’s objective of setting interest rates with an eye on taming inflation.
Sri Lanka’s largest savings pool, the EPF, delivered returns lower than inflation for decades. This was due in part to fund managers’ overwhelming preference for fixed-income asset classes that don’t respond well to inflation (most retirement savings are invested in government debt). Focusing on multiple objectives inevitably also erodes Central Bank independence.
This is because establishing priorities when there are trade-offs – in government debt management and retirement savings fund management – requires political decisions. Central bankers themselves cannot make these decisions as they are unelected, and implementing political decisions makes it difficult to separate them from the resulting outcomes. Cabraal’s successor was Arjuna Mahendran. Two controversial bond auctions conducted during his tenure resulted in government having to pay far higher than market interest rates on securities. Much of these profits went to a firm controlled by his son-in-law. A parliamentary committee is now probing the matter.
Profiting from insider information is an offence. However, such a crime can take place irrespective of who manages the debt office. Responsibility for the disrepute and erosion of credibility of the Central Bank – which shouldn’t have been managing government debt issuance in the first place – lies with its then Governor. Restoring that credibility is now a task for Coomaraswamy.
in his first address to Central Bank staff, Coomaraswamy outlined what he contended were three guiding principles for the bank: integrity, technical excellence and professionalism. The inclusion of technical excellence among these guiding principles brings to the fore the idea that central banks are often at the vanguard of economic research and that this contributes to evidence-based decision making.
Central Bank staff in Sri Lanka rarely publish peer-reviewed economic research. Despite its large staff, large budgets and its contribution to collating much of the island’s economic, financial sector and monetary data, the Central Bank’s not weighing in on the economic debate with peer-reviewed research, is glaring. The new Governor’s focus on technical excellence may require him to challenge evidenced based rigor’s current standing in the hierarchy of economic decision-making.
The other principles – integrity and professionalism – are also critical if the bank is to reclaim its lost credibility as well as prepare for the challenges that a high-growth economy’s monetary authority should be ready to face.
[pullquote]Improving Central Bank credibility is a slog; one which Coomaraswamy may have to bear the bulk of. A great central bank is as much about its governor as it is about the institution[/pullquote]
Sri Lanka’s rise though the middle-income league table will alter the structure of the economy, especially if it trades more with the world and allows economic freedoms to flourish. An economy that is deeply integrated with the rest of the world will require of the central bank to nimbly react to developments elsewhere.
The dent that the Central Bank’s monetary autonomy has taken many not appear that serious if major cracks appear in the financial sector, exposing lax regulation. There is reason to be worried. The current financial climate is ideal for asset bubbles to appear, as the economy expands rapidly and credit grows in step.
When they pop, asset bubbles expose old shenanigans and encourage new ones, another likely outcome at some of Sri Lanka’s weak, ill-governed, subprime lending firms. Faced with rising dud loans and tightening margins, owners and managers will gamble for salvation, taking even greater risks and speculative bets.
They will conceal non-performing loans in the expectation that the prices of assets backing them will somehow recover, that these loans can somehow be packaged as a security and sold, or that the financial firm itself can be sold while the muck remains hidden. Many small, subprime lending firms – commonly referred to as finance companies or Licensed Finance Companies (LFC) – are badly managed and have a chilling disregard for good governance.
The regulator’s initiative to force consolidation – which had many weaknesses but was also critical for continued financial system stability – has been abandoned. That policy of consolidation would have resulted in the weakest players being absorbed by bigger finance companies and commercial banks, or the weak firms merging with each other to form larger, better capitalized finance companies.
Some consolidation happened, but the problem of too many small players, all way too exposed to economic down cycles, still remains.
India’s financial sector’s biggest banks are in a serious mess due to loans they granted in the heady years leading up to 2011. Governor Rajan has been forcing a balance sheet clean-up, which has solidified market confidence instead of shaking it.
Improving Central Bank credibility is a slog; one which Coomaraswamy may have to bear the bulk of. A great central bank is as much about its governor as it is about the institution. India’s Rajan has demonstrated that at times of crisis – like the one now faced by Sri Lanka’s Central Bank – a governor can affect change, build credibility and alter course. Coomaraswamy is perhaps the best man for the job.