Sri Lanka’s central bank, an agency that hires a large number of students with economic degrees, has set a bad example for politicians acting in a bureaucratic fashion with loan price controls, mimicking the ill-advised price controls imposed by the Consumer Affairs Authority (CAA). The CAA’s price controls often lead to acute shortages and distort markets beyond comprehension, leading to bigger burdens on consumers and businesses.
Price controls are unnecessary state interventions in business, which can have damaging effects. Lending rates have started to come down as deficits are being managed, state enterprise losses are cut and private credit is negative, reducing credit demand.
The only saving grace about the recently announced lending rate controls is that it is better than cutting policy rates with reverse repo money and triggering balance of payments deficits. Politicians who put pressure on the central bank to cut rates should beware. They will find themselves rejected by the electorate when the currency falls.
No Lessons Learnt
But price controls can have damaging effects. Excessively low mandated rates were seen during the 2020-2021 output gap targeting crisis which ended in default. In 2019 the central bank set deposit rate controls, after destroying the rupee from 153 to 182 to the US dollar and slashing the real value of deposits.
After cutting rates and creating a crisis in 2018, the central bank then put price control on deposit rates compounding their error and preventing the market mechanism of giving some protection to the savers. It reversed the actions of the 1990s under Governor A. S. Jayewardene.
Once admin controls start, politicians and others also get the bad habit. When the agency with the largest amount of economists engages in bureaucratic controls, undermining market forces, what can be expected from other state agencies? These controls were abandoned in the 1990s in the course of saving the country from the high inflation of the 1980s. In the 2020-2021 money printing bout all kinds of price controls were set. To save the country from hyperinflation these controls were removed in 2022.It is sad to see them coming back again.
The most damaging section of the 2023 direction is not to raise interest rates which were already brought down. Credit markets were working from April 2022 to August 2023. Now controls are starting again.
When crises take place, bureaucrats and politicians tend to bring more and more controls and they expand exponentially, which classical economists all the Ratchet Effect. All these controls and bad habits will take a toll on de-regulation reforms and economic efficiency in the future.
Is the policy rate the correct rate?
Lending controls assume that the policy rate is the correct one. Whatever the current controls, what is indisputably correct, since the end of the war in particular, is that the Monetary Board had woefully failed to set the market rate. The serial currency crises and eventual default are mute testimony to its policy errors.
That is why this country stumbled from one currency crisis to another without a war and ended up in default. Already it is difficult to say what the correct interest rate is because the central bank is doing complex two-way
open market operations, selling Treasury bills outright in large quantities and injecting short term money at the other end. It is a bad practice to oversell Treasury bills and encourages banks to borrow from short-term windows and depend on the easy money from the central bank to buy bills.
Moral Hazard
The central bank is also targeting the call money rate with a narrow corridor of one per cent. With overselling of central bank-held treasury bills at at least the rate, at least there is no excess liquidity in money markets.
A wide policy corridor allows the correct risk of individual banks to be reflected in the interbank market. That is why old central banks, at a time when banking crises were rare, forex shortages and BOP deficits were completely absent, policy corridors were wide and rates fluctuated freely.
Old central banks also did not use Treasury bills to engage in open market operations, but private bills. It is bad enough that Treasury bills misrepresent the risk of individual banks to which money is injected by the central bank
but it is worse when narrow call rates misrepresent call rates with individual counterparties.
Some foreign banks completely refused to lend to local banks last year. One can argue that in such a condition it is okay to give money through the standing facilities due to exceptional circumstances. Certainly, the money deposited in the central bank can be loaned to another bank.
But to have standing facilities with narrow policy corridors in normal times is to invite trouble. That is why countries with central banks and standing facilities suffer worse banking crises than in currency-board and dollarized countries, even when banks in the anchor currency country fail.
Though banks failed wholesale in the US after Ben Bernanke misled Alan Greenspan into cutting rates and running an 8-year Fed cycle, neither Hong Kong banks (a financial centre with a currency board) nor Panama (a financial centre that is dollarized) suffered the same fate.
Even the Euro region suffered, by essentially importing US-style policy, partly due to the desire to prevent a sharp appreciation of the currency. Panama which was dollarized, has a high private credit to GDP ratio.
Panama is an example of why the lack of a lender of last resort facilities and interbank market based on risk prevents banking crises. An IMF report on Panama said as follows:
“Banks are well capitalized, profitable, and liquid. The stress tests conducted during the 2011 FSAP suggest that the system could withstand a wide range of shocks, including a repeat of the Lehman episode. However, the analysis was constrained by data gaps: for example, the SBP does not collect regularly data on loan write-offs, the construction sector, property prices, and loan-to value ratios.
“Given that the interbank market is not operating smoothly and that important safety net elements such as a lender of last resort and deposit insurance are missing, banks hold significant liquidity buffers. On the other hand, some banks have a high degree of concentration in their interbank liquidity holdings, and some small banks appear vulnerable to liquidity shocks. Bank failures have been rare, of limited size and complexity, and have been effectively managed, generally with no losses to depositors or creditors.”
Economists in the IMF or central banks now think that a fixed call money rate is normal. It is not. The fixed call rate was an invention of the New York Fed Governor Norman Strong which led to the Great Depression, the eventual collapse of the gold standard, and the emergence of complete fiat money.
Sri Lanka is in a bad shape now. In 2018 the country was in better shape, though foreign debt was climbing steadily under flexible inflation targeting. Now there is no rating space to indulge in bureaucratic controls. The policy rate has been consistently wrong, especially since the end of the war.
In a reserve-collecting central bank, it is easier to say whether the policy rate is right or wrong. If there are forex shortages (reserves are lost) the policy rate is wrong. Under the IMF programme, the correct policy rate is the one that allows reserves to be collected, which is necessarily higher than one in which reserves are stable. This is no time to impose arbitrary prices and undermine the market.
“One other control granted to the central bank, that of limiting interest paid by commercial banks on deposits or charged on loans, is intended to be used only sparingly,” an unknown analyst wrote in The Banker magazine in 1950.
Mr. Exter declares that it is necessary only to prevent “abuses” (such as unsound competition among banks in the form of excessively high rates of interest on deposits).
“It will be obvious from this summary that the new Monetary Board is going to be given almost unlimited power to control the banking system of Ceylon – a power which, if misused, could do irreparable harm to the island’s economy.”
Unfortunately, this warning has come to pass. An even worse central banking law, which has codified the policy errors made in the last decade (flexible inflation targeting, flexible exchange rate, printing money and output gap targeting) has now been enacted. It is to be hoped that the price controls are not the beginning of the end.