Monetary Easing – Central Bank’s Policy Dilemma Comments Off on Monetary Easing – Central Bank’s Policy Dilemma 770

The Monetary Policy dilemma is nothing new as we have seen US, Japan and other developed economies question the monetary policy tools used to stimulate or contract the economic activity. The US president recently blamed the Federal Reserve Bank that its action of raising interest rates has slowed the US economy. A similar trend has also been seen in India in that the Reserve Bank has reduced its policy rate in the eye of national elections. The Reserve Bank of India Monterey policy cuts its benchmark repo rates to 6.25 percent citing slow economic growth and sharply lower inflation. The committee also change its monetary policy stance ‘Neutral” from the previous outlook of policy tightening. Monetary neutrality comes just a few months after Urjit Patel the former governor resigned amid widening differences with the government over various economic and regulatory issues including the government perception that monetary policy was too tight.

Monetary-EasingThe new governor Shaktikantha Das said that after the announcement on the rate cut the slowing down in the economy and sharply lower inflation opened up for policy action. The need in his view is to stimulate private investment and consumption to address growth, given that the inflation target had been met. India’s inflation rate has been fallen from an annual average of about 10 percent to 3.6 percent in the 2018/2019 financial year. The phase of price increase is now below the target set in the reserve bank inflation targeting framework of 4 percent with a range of 2 – 6 percent plus or minus. In January Indian industrialists met the Governor of the Reserve Bank and appealed for a 50 percent rate cut and reduction in bank’s capital ratio to facilitate the flow of credit to industries to reduce their cost.

Sri Lanka Prime Minister has also appointed a committee to examine why banks have not reduced lending rates in spite of the fact that the Central Bank has reduced rates on two consequent sessions.

The recent announcements by Monetary Board of the Central Bank of Sri Lanka that the reduction of the Reserve Ratio on all deposits of commercial banks from 6 percent to 5 percent from March 1st 2019 following a reduction in the reserve ratio from 7.5 percent to 6 percent in mid-November 2018 comes in at a time when Sri Lanka is facing an daunting task to stimulate the economy given its below potential growth rate achieved over the past three years .Bank maintained their policy rates on deposits and lending facilities unchanged at 8 and 9 percent respectively on both occasions. The reduction in the reserve ratio in February 2019 is justified on the ground that some policy intervention by the Bank is warranted to address the large and persistent liquidity deficit in the money market although is natural on the change of policy rates.

Monetary Policy review by the Monetary Board in February and March have noted the following;

  • The real economic growth remained subdued at 3.2 percent during 2018, compared to a growth of 3.4 percent in 2017. The growth of industry activities slowed down significantly to 0.9 per cent during 2018, mainly as a result of the contraction in construction.
  • Real GDP growth will remain moderate in 2019 as well. The continued low growth emphasizes the need for implementing growth enhancing structural reforms expeditiously.
  • The deficit in the trade account contracted with the continued growth of exports alongside a decline in imports in response to the policy measures to curtail non-essential imports. Increased tourist arrivals in the first quarter of 2019, improved earnings, although workers’ remittances moderated during the first two months of 2019.
  • Proceeds from the issuance of the International Sovereign Bonds (ISB) helped increase gross official reserves to an estimated US dollar 7.6 billion by end March 2019.
  • Noticeable growth of earnings from tourism continued to support the current account although worker remittances marginally declined in 2018.
  • The recent uptick in inflation was driven by the upward revisions mainly to prices of fuel but inflation expectations indicate that it is likely to remain within the desired range of 4-6 percent in 2019 and beyond, with appropriate policy adjustments.
  • Credit extended to the private sector decelerated to 13.6 percent during the first two months of 2019, from 15.9 percent in December 2018. broad money (M2b) also slowed down during the first two months to 14.4 percent in February 2019 from 13 percent in January 2018 of the year. A growth of around 13.5 percent is expected in private sector credit in 2019, while broad money (M2b) is expected to grow at around 12.0 percent in 2019.
  • The Monetary Board views that broad money (M2b) growth is likely to support economic activity adequately without creating excessive demand driven inflationary pressures.
  • The domestic money market has improved reflecting Call Money Rate declining by 45 basis points so far during 2019, however other market interest rates continued to remain at high levels thus far in 2019. The Central Bank may implement mechanisms for more effective downward adjustments in market interest rates.
  • At present there is a slowdown in private sector credit. A Working Committee appointed on the directions of Prime Minister Ranil Wickremesinghe is expected to submit a report recommending necessary actions to reduce the private credit interest margin.

The Central Bank Governor Dr. Indrajit Coommaraswamy explained at the press conference in February 2019 that the policy intervention to inject LKR 60 bn was to ease liquidity shortage. This liquidity shortage continued to prevail despite the liquidity injection of LKR 90 bn in November 2018 through a reduction in reserve requirements. The Governor indicated that liquidity shortage in the market is around LKR 100 bn and expects that the market to find the balance in the shortfall of around LKR 40 bn. He also hinted that large liquidity injections could spill into more imports, thereby adversely affecting foreign reserves and the exchange rate. The governor’s view was that the lower interest rates encourage consumption related loans, with the public opting to import cars or to invest in construction industry that has a significant import content. The Governor’s dilemma is how growth could be fostered without undue pressure on external reserves.

International Reserves of Sri Lanka declined to USD 6.2 bn against predetermined short term (less than 1 year) liabilities which stood at USD 6.5 bn placing the Central Bank on a negative reserve position. The reserve position was USD 6.9 bn in December 2018, down from USD 07 bn in November 2018. The reserves are partly protected with 200 percent cash deposit margins on import of motor vehicles and 100 percent cash margins on consumer durables. These policy actions have substantially reduced imports in recent months. The test is whether the exchange rate will remain stabilized once these direct controls on imports are removed.

Monetary Easing Chart

Source: Central Bank of Sri Lanka

As shown in the chart, nominal interest rates have moved steadily in an upward direction although the differences between them and the NCPI Core Inflation Rate have narrowed owing to a steep increase in the core inflation rate. The core inflation rate which has been well below the target range of 4 – 6 percent has entered in to inflation target range in January – March 2019. It is likely that this trend may continue with seasonal demand and the fuel price revisions that have already taken place.

Expressing optimism on the inflation outlook, Governor Coomaraswamy forecasted that inflation would remain in the range of 4 -6 percent although it is volatile to fuel price adjustments and other administrative price revisions. He explained that the uptick in inflation rate in January to March 2019 was due to non-food inflation driven by education and house rentals. A further upward pressure is expected from fuel price adjustments and likely administrative price revisions on cement, milk powder and LP gas.

Monetary-EasingThe monetary policy review underpins the underlying risks of a ballooning trade deficit. Export growth remains modest. Import growth currently remains subdued due to credit restrictions on imports. The removal of such restrictions may require to let market fundamentals to work in terms of the Government policy framework particularly in the context of the ongoing IMF extended fund facility to improve the overall macro-economic conditions. But such relaxation remains a challenge in the context of slippages in government budget and recovery in imports following the removal of deposit margins of imports. The exchange rate appreciation may short live, once imports picked up in the second quarter and outflow on oil imports at high prices and values due to prevailing electricity shortfall. But it is doubtful whether in an election year imports growth could be kept under policy control for long. Reserves are kept stable and exchange rates allowed appreciating in the backdrop of short term inflows from external borrowings and subdued imports in tourism and remittances are perhaps the only supporting elements from the 1st quarter 2019 particularly, motor vehicles, milk powder and consumer durables.

Tourism and remittances are perhaps the only supporting elements from the point of view of the stabilizing balance of payments but remittance inflows of around USD 07 bn too have slowed down. The flexibility available to the Central Bank to conduct market based monetary policy in election times (2019 May) remain illusory as pressure is building from the fiscal slippages, recovery in imports and private sector for low interest rates. Exchange rate may remain vulnerable and deficits in market liquidity are likely to persist. Bank though, have reported large profits also subject to rising non-performing loans, accounting requirements, higher capital requirements and taxes. Excessively high real interest rates may be a reality with modest growth in GDP as Governor anticipated in February, 2019.

The Monetary Policy Review announcement on 10th April 2019, came at a time that the 2018 economic growth data pointed to a further slowedown in GDP growth of 3.2 percent and also following the fiscal policy stance announced in the 2019 National Budget. It will also provide the Central Bank to respond through its policy stance to the 2019 National Budget. Yet the Central Bank did not change its position on the policy rates expressing downside risks and concerns over inflation and external stability. The concerns have risen as to whether current monetary policy stance is appropriate for the country’s tumbling economy. Some also anticipate monetary policy easing in view of continued slowdown in economic growth.

However, the recent staff review by the IMF advised the Central Bank of Sri Lanka to continue to maintain a prudent and data dependent monetary policy standing ready to tightened policy rate should inflationary pressers re-emerged.

By: BiZnomics Special Economic Correspondent

BiZnomics Global Outfront Comments Off on BiZnomics Global Outfront 610

US – China Trade Talks

After months of trade war, the US and China agreed to a 90-day truce to work out their differences. It was scheduled to end on Friday, but President Trump lifted the ultimatum to increase tariffs after he was satisfied by progress made in several rounds of talks in Beijing and Washington.US China Talks

A White House economic official, Larry Kudlow, said on Thursday the two countries were on the brink of a ‘historic’ trade agreement. A meeting between Trump and his Chinese counterpart Xi Jinping, was also expected soon. After the latest round of talks in February, US Agriculture Secretary Sonny Perdue tweeted that China had committed to buying ‘an additional’ 10m tonnes of soybeans as a ‘show of good faith’.

US farmers rely greatly on such trade with China: in 2017 around a third of US soybean production – worth $14bn -– was exported there, where it is used for animal feed.

Chinese tariffs had already hit America’s farming regions hard.  Exports plummeted last summer when China imposed tariffs on US soybeans and other agricultural products.

Donald Trump has requested China to abolish tariffs on US farm produce arguing that it is very important for US farmers.

In the meantime, South China Morning Post on 19th April reported that China regrets WTO ruling that China’s Tariff Freight Quota System for rice, wheat and corn violates international trade rules. The verdict was given in a case filed by the administration of former President Barak Obama in December 2016.

The US government is also seeking a total reforms of the WTO including re-visiting China’s role in the international trading system as the US believes China should no longer designated as a developing country, enjoying favourable trade treatment as China has emerged the world’s second largest economy.  

 

Brexit Deadlock Continues

The British Prime Minister said she would step down if and when her Brexit deal was delivered. There was a desire for ‘a new approach, and new leadership’, she told a meeting of Conservative lawmakers. However, members of the House of Commons voted on a range of measures designed to break the impasse over Brexit — but failed to agree on any of them.

Brexit Deadlock ContinuesThe European Union has requested the UK to accept a six months delay with an option to leave earlier if the UK Parliament can agree to a deal, The European Union leaders agreed to another delay to the UK schedule withdrawal from the EU until October 31. In the meantime, the European parliament election is due in late May and if the UK does not take part in the election process it would be required of the UK to leave on June 01st without a deal as some observed. The Prime Minister of UK has suggested that she could still manage to get her withdrawal agreement passed through parliament, in time to avoid UK taking part in the European elections.

 

New Head at World Bank

Following President Trump’s announcement that Mr. Malpass would be the US candidate for election as the next President of the World Bank, Mr. Malpass won unanimous approval from the executive board of the bank, which has 25 members. The US holds a 16% share of board voting power and has traditionally chosen the World Bank’s leader. Traditionally, the US picks the World Bank President, Europeans choose the IMF Managing Director, and the Japanese do the same for the Asian Development Bank.

David Malpass has been selected as President of the World Bank Group for a five-year term from April 9, 2019. Mr. Malpass previously served as Under Secretary of the Treasury for International Affairs for the United States.  As Under Secretary, Mr. Malpass represented the United States in international settings, including the G-7 and G-20 Deputy Finance Ministerial, World Bank-IMF Spring and Annual Meetings, and meetings of the Financial Stability Board, the Organization for Economic Cooperation and Development, and the Overseas Private Investment Corporation.  

New Head at World BankIn 2018, Mr. Malpass advocated for a capital increase for the IBRD and IFC as part of a larger reform agenda featuring sustainable lending practices, more efficient use of capital, and a focus on improving living standards in poor countries. He was also instrumental in advancing the Debt Transparency Initiative, adopted by the World Bank and IMF, to increase public disclosure of debt and thereby reduce frequency and severity of debt crises. 

Prior to becoming Under Secretary, Mr. Malpass was an international economist and founder of a macro-economic research firm based in New York City. Mr. Malpass served as chief economist of Bear Stearns and conducted financial analyses of countries around the world. 

Earlier in his career, Mr. Malpass served as the U.S. Deputy Assistant Secretary of the Treasury for Developing Nations and Deputy Assistant Secretary of State for Latin American Economic Affairs. In these roles, he focused on an array of foreign policy and development issues, including the United States’ involvement in multilateral institutions; the World Bank’s 1988 capital increase, which supported the creation of the Bank’s environment division; the Enterprise for America’s Initiative; and Brady bonds to address the Latin American debt crisis. He also served as Senior Analyst for Taxes and Trade at the U.S. Senate Budget Committee, and as Staff Director of the Joint Economic Committee of the U.S. Congress.

Mr. Malpass has served on the boards of the Council of the Americas, Economic Club of New York, and the National Committee on US–China Relations. Mr. Malpass earned his bachelor’s degree from Colorado College and his MBA from the University of Denver.  He undertook advanced graduate work in international economics at the School of Foreign Service at Georgetown University.

The World Bank President is Chair of the Boards of Directors of the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The President is also ex officio Chair of the Boards of Directors of the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA), and the Administrative Council of the International Centre for Settlement of Investment Disputes (ICSID).

Some worry that Mr. Malpass, a critic of the bank, will seek to reduce its role. In the past, he has described the World Bank as too big. He has said he would like to lend less to middle income countries like China, which he argues are financially strong enough.

Speaking at an event at the Council on Foreign Relations back in 2017 he said: “Multilateralism has gone substantially too far – to the point where it is hurting US and global growth”. However, when his predecessor Jim Kim asked shareholders for more money, it was David Malpass who – in exchange for reforms at the bank – helped make it happen. Last year, he was part of negotiations over a package of World Bank lending reforms.

Ivanka TrumpThe US agreed to back a plan for shareholders to inject $13bn (£10bn) into the World Bank and its private lending arm, with conditions that aimed to limit the bank’s lending, and focus resources more on poorer countries. The reforms are aimed at pushing more middle-income countries towards private sector lending, and limiting World Bank staff salary growth.

White House Senior Adviser Ivanka Trump speaking during an interview with Associated Press, Wednesday April 17, 2019 in Abidjan, Ivory Coast, where Trump is promoting a White House global economic program for women said her father asked her if she was interested in the job of World Bank Chief but she was happy with her current role in the administration.

President Trump recently told The Atlantic: “I even thought of Ivanka for the World Bank. She would’ve been great at that because she’s very good with numbers.”

Ivanka Trump worked on the selection process for the new head of the 189-nation World Bank, David Malpass. She said he’ll do an ‘incredible job.’

 

US Monetary Policy Normalization

US Monetary Policy Normalization President Trump called on Federal Reserve to lower interest rates and wants return of quantitative easing arguing that the Central Bank’s policies have held back the US economy and there is no inflation.The Federal Reserve, which has increased interest rates numerous times in the last few years, recently signalled that it does not plan to increase interest rates any more for the remainder of this year.

Beyond simply cutting interest rates, President Trump also wants the Fed to bring back its policy of quantitative easing, to increase liquidity in the market and keep interest rates low. In the wake of the financial crisis in 2007/2008, the Fed enacted QE, but that program ended in late 2017.

According to Trump, if the Fed were to undertake those policies, the economy would improve dramatically, despite the fact that in Trump’s eyes, things are already going well.

Global Growth Outlook ‘Precarious’

International Monetary Fund (IMF) Managing Director Christine Lagarde in a preview of the April 12-14 IMF and World Bank Spring Meetings, said that global growth has lost momentum amid rising trade tensions and tighter financial conditions. The IMF Chief explained that the global economy is “unsettled” after two years of steady growth, with the outlook “precarious” and vulnerable to trade, Brexit and financial market shocks. However, she said that the IMF does not anticipate a recession in the near term, and the Federal Reserve’s “more patient pace of monetary policy normalisation” will provide some thrust to growth in the second half of 2019 and into 2020.

Global Growth Outlook 'Precarious'Lagarde cautioned, however, that years of high public debt and low interest rates since the financial crisis a decade ago have left limited room in many countries to act when the next downturn arrives, so countries need to make smarter use of fiscal policy. This means striking a better balance between growth, debt sustainability and social objectives and acting to address growing inequality by building stronger social safety nets.

Lagarde also said that the IMF has revised its analysis of the US-China trade war’s effects, showing that if all trade between the world’s two largest economies were subjected to a 25 percent tariff, US gross domestic product (GDP) would fall by up to 0.6 percent while China’s would fall by up to 1.5 percent.

Nobody wins a trade war,” Lagarde added. “That is why we need to work together to reduce trade barriers and modernise the global trade system.”

Source: News Agencies

Was Sri Lanka forced into a ‘Balance Sheet Recession’? 0 334

By Dr. Kenneth De Zilwa

Background

The Central Bank of Sri Lanka had come under increasing criticism over its Inflation Targeting hedonistic regime adopted over the past 5.5 years which saw the country pushed to a virtual standstill. During this period we witnessed the real economy crumble, recording its worst GDP growth trend recording a decline in GDP from 5.0pct in 2015 to 2.3pct in 2019¹, the lowest growth recorded since 2001². Despite the glaring evidence of a declining GDP trend the Central Bank of Sri Lanka ably supported by the IMF continued to drum up the rhetoric on the need for austerity measures, as a solution for Sri Lanka’s economic pains. The announcement sent shivers down the spines of many alternative schooled economists. World-renowned economist
Paul Krugman was quoted saying

“every country that introduced significant austerity has seen its economy suffer, with the depth of the suffering closely related to the harshness of the austerity”

 

therefore, it is mind-blowing how Sri Lankan Central Bank could advocate such policies. Fueling this announcement was also the common belief by Central Bankers that excess money supply or printing money caused ‘galloping inflation’ – a myth, which resulted in hawkish policy measures being adopted by Central Bank. It was, therefore, a matter of time before the real economy was choked with high real interest rates, which was among the highest in the Asia Pacific countries in 2018 (Figure 1).

What is interesting to note is that contrary to the theory that high real interest rates lead to increased national savings, Sri Lanka’s national savings to GDP data (i.e. national savings rate measures the amount of income that households, businesses, and governments save), did not indicate any such linear progression, as the national savings trend had steadily declined from a high of 30pct in 2014 to 25pct in 20194.

The declining GDP data trend captured in (Figure-2), confirms that the country was now in dire straits and heading towards greater depression, requiring a significant change in direction from the hawkish monetary policy approach and growth retarding fiscal framework that existed, to a pro-production and pro-growth framework. It can be argued that an inevitable outcome of both high tax rates and inconsistent monetary policy measures contributed to the rising of non-performing loans in the banking system, thereby increasing the gross NPL ratio by 38pct on a year on year basis, from 3.4pct in 2018 to 4.7pct in 2019, or in other words, gross NPLs increased from LKR 263 billion to LKR 382 billion which was the highest year on year increase since 2015, according to the 2019 Central Bank Annual Report.

It is evident that fresh thinking needs to be adopted towards inflation targeting and the problem must be approached from a business model perspective. Unfortunately, this fresh perspective was not forthcoming during the period under review (i.e. 2014 to 2019). Cambridge University, development economist Prof. Ha Joon Chang has highlighted in his book titled “Bad Samaritans- the myth of free trade and the secret history of capitalism” that many such growth retarding monetary and fiscal policy tools and false theories have been used extensively against developing countries by developed countries, preventing and stifling their economic development journeys. Empirical evidence suggests that Sri Lanka too has fallen prey to this austerity and inflation targeting trap.

THE MYTH OF INFLATION TARGETING

With the collapse of the Bretton Woods system in 1970 which focused on maintaining a fixed exchange rate, global superpowers and neo-classical i.e. monetarist school of economic thought were looking for another similar type of a potent policy tool to support their global monetary supremacy agenda, which would ensure that the standards were set for other countries to follow. Central Banks of developed countries had to demonstrate that they cannot control inflation as both the business community and the general public had lost faith in their ability to do so, having often missed their target by a long shot on many occasions. This very fact was aptly highlighted in 2009 by Maurice Saatchi, Chairman, of the Centre for Policy Studies, United Kingdom.

A closer examination of ‘inflation targeting’ would reveal that the whole notion is based on the premise that long-term economic growth is best achieved by maintaining stable prices, and that it could be done by controlling prices i.e. inflation. This approach is typically characterized, by the announcement of official target ranges for inflation by the Central Banks at one or more time horizons, while they explicitly acknowledge that low and stable inflation is the overriding goal of monetary policy.

Herein lies the problem, when the National Consumer Price Index NCPI (Base 2013=100), is based on data from the Household Income and Expenditure Survey conducted in 2012/13 which is highly skewed towards food (45pct of the basket) and even the non-food components (55pct of the basket). The weights in both categories are dependent on import prices. In such situations, exchange rate pressure builds up and as a tradeoff for managing the pass-through of exchange rates, monetary policy i.e. inflation targeting mantra, has been predominantly used as its solution. How can price stability be achieved in a country when it has sacrificed its domestic food supply and is heavily import depended on its basic food requirements for its people, apart from energy supply, household items, and fuel supply? If inflation rises because of such external supply-side shocks, it is a no brainer that the Central Bank of Sri Lanka would be compelled to increase its key policy rates expecting to go by the rule of inflation targeting. But in fact what it does is make matters worse causing more damage to the real economy, as balance sheets of companies suffer from higher debt financing costs and raw material costs, thus eroding profitability i.e. national savings. The International Labor Organization in a research paper (2011) validated this observation when it stated that “implementing inflation targeting regimes represents a major challenge in the presence of supply-shocks which are a common phenomenon in developing countries”.

Therefore, in adopting such a one-dimensional approach the Central Bank of Sri Lanka could be literally ‘shooting itself in the foot’ and together with it the entire real economy. This phenomenon is because most Central Banks are not trained to look at corporate balance sheet behavior, leverage, and factors affecting revenue conditions. Inflation targeting has been globally rebuked and many Central Banks do not go by this indicator alone, anymore. According
to a research paper published in 2015 by the Peterson Institute for International Economics (PIIE) claimed that inflation targeting is a myth and said to be the root cause for retarding economic growth of developing countries, quote, “Simple inflation targeting lowers growth in developing countries”. In a separate research study undertaken by Ricardo Brito and Brianne Bystedt titled ‘Inflation Targeting in Emerging Economies: Panel Evidence’, published in the Journal of Development Economics, 2010, (volume 91, issue 2, pages 198-210), the authors examined panel data samples of 46 developing countries over 27 years, (from 1980 to 2007), in which they found evidence that “inflation targeting by the developing country Central Banks, in fact, was the cause of reduced (economic) growth”.

This is could not be truer from a Sri Lankan perspective too. For at a time when corporate business sales turnovers have been negatively impacted as a result of internal shocks caused by draughts, floods, and terror attacks and the exchange rate depreciation viz a viz the US dollar, any form of growth reviving strategy seems to be a miss. While more growth retarding austerity measures were spoken of such as increased taxes (i.e. fiscal strangulation) more inflation targeting policy measures saw real interest rates at its highest making matters worse for corporate balance sheets as they hemorrhaged cash on the back of higher debt levels and continued low earnings saw the collapse in real GDP (Figure-3). Evidence indicates that the Central Bank without understating the implication on corporate balance sheets given their hedonistic inflation targeting policy approach – a purely mechanical process, caused many businesses to involuntarily close down, pushing the banking sector into jeopardy with un-serviceable loans that kept piling on in the books of banks and (i.e. banking non-performing loans reached 13.0 percent in some instances), thereby increasing the overall risk to the country’s financial stability (Figure-4). The decline of economic activity in the country also saw the national unemployment rate increase to 5.1pct in Q3 of 2019 from 4.4pct in Q2 2019.

 

 

 

 

 

 

BALANCE SHEET RECESSION, INFLATION TARGETING, AND DEMAND FOR CREDIT

Bank of Japan (BOJ) was faced with a balance sheet recession and attempted inflation targeting in the 1990s and until 2000s, and finally admitted that it failed to inflate the economy despite the flood of money in the domestic market. The excess money supply did not create inflation nor did it help pull the economy out of its 20-year long recession. In 2013 too Bank of Japan once again set an inflation target of 2.0pct as Governor Haruhiko Kuroda took office, seven years on, inflation has remained a significant distance from that goal. Data showed core consumer prices rose by just 0.37pct during this period. Unlike Japan, the USA’s President Donald Trump did understand that inflation cannot rise despite the flush of money supply when corporate balance sheets are significantly stressed with debt, and thus the demand for money is not plausible. While accelerated loan repayments i.e. debt repayments, only makes matters worse as BOJ too faced similar problems and was flushed with money supply, that no one wanted, as demand for money disappeared causing commercial bank lending to decline sharply recording a negative 1.0pct in the 1990s reaching negative 7.0pct by 20005. Nomura Research Institute economist, Richard Koo, wrote extensively on this matter and argued that deleveraging (i.e.paying down debt) by private sector companies caused the recession in Japan. He pointed out that when corporate balance sheet debt stock rises, servicing runs into trouble when there is a lack of domestic demand, resulting in an asset price collapse while debt i.e. liabilities remain on the balance sheet.

This phenomenon of cash flow compression causes private sector balance sheets to go underwater and deleveraging commences. During the period between 2002 and 2003 Japanese companies paid down USD 260 billion worth of loans, when as per the monetary theory companies should be borrowing at near-zero interest rates.

In such a situation, the turnaround is only possible with debt deflation (i.e. writing off/downsizing), and economic policies are targeted at regaining the financial health of companies and improving their balance sheets. It is important to note that in situations of debt deflation i.e. downsizing, (as a result of slower GDP and declining revenues) businesses are forced to take drastic action to repair their balance sheets by either increasing internal savings i.e. cutting costs, or paying down debt by fire sales of assets or a mix of both methods could also be on the table. This desperate act of deleveraging reduces aggregate demand for money and inflationary pressures decline, thereby throwing the economy into a tailspin and subsequent recession, which can be termed ‘Balance Sheet Recession’. It is important to have a mechanism to insulate companies when faced with or unknowingly placed in such balance sheet recessionary situation by the Central Bank’s own austerity measures. Therefore, in such situations, businesses should get some reprieve by way of a debt-moratorium or a write off as they require time to restructure their debt. In the USA according to Chapter-11 bankruptcy code 6, a petition could be filed, and voluntary bankruptcy could be declared by the debtor to reorganize existing debt, or it could be an involuntary petition, which is filed by creditors or creditors that meet certain requirements. Sri Lankan businesses do not have this luxury when faced with a ‘Balance Sheet Recession’ situation.

Therefore, until such time businesses are back in good shape with strong balance sheets, having gained production capacity in order to capture market share, growing revenues, and expanding its asset base any form of monetary stimulus or fiscal stimulus will not have any significant impact on inflation. For the lack of demand for money or credit, paves the way into the decline for goods and services. This is what saw in Japan and now we see it happening in the USA too and President Donald Trump has managed to put a stop to Federal Reserve’s inflation targeting phobia, understanding the implications of balance sheets and the need to gradually deleverage post an economic crisis, such as that witnessed in 2009/2010 period. President Trump was critical of the Fed’s hawkish monetary policy stance and called it “very, very disruptive” as they were contemplating raising interest rates too quickly too soon, thereby squeezing out the air in profitability and not making room for businesses’ balance sheets to be cured and repaired.

GROWTH ORIENTATED MONETARY POLICY

Thankfully in Sri Lanka too we see the dawn of a new monetary policy framework that is now gradually taking shape in the parlance of decision making, and that too is based on ‘Balance sheet based economics’ which is considered when factoring monetary and fiscal policies. Therefore, we could expect a more growth-oriented Central Banking to emerge in the months ahead. A pre-condition in this process must be to stimulate businesses and to create new
business models to look at external markets by enlarging the economic pie by way of using unconventional monetary and fiscal policy in the new normal economic environment that we have come to embrace. Herein, the restructuring of SME and ushering an Agro industrialization transformation is pivotal in this process of reorienting the economy. The Central Bank of Sri Lanka and Monetary Board should think out of the box and adopt new tools and have in place new mechanisms to examine corporate balance sheets, understand them, and work towards strengthening them as part of key focuses in achieving full employment and macroeconomic stability. Thus moving away from its preconditioned (flexible) inflation targeting and balance sheet contracting ‘austerity mindset’ which world-renowned economist Paul Krugman admitted has failed miserably globally7.

The Monetary Board and the present government seems to have understood this “Balance Sheet Recession” aspect and have moved expeditiously with initially providing fiscal support by way of tax cuts and also have decided to inject liquidity and reduce the cost of borrowing for companies by slashing the Statutory Reserve Ratio (SRR) by 2pct, and the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank to 5.5pct and 6.5pct respectively. The cost of debt was reduced on four occasions within the year initially by 50 basis points and 25 basis points, respectively, with effect from 30 January, 16th March, and thereafter by 50 basis points once again on the 3rd April and on 6th May 2020. While introducing the debt repayment moratorium and credit guarantee scheme to enable businesses to access much-needed funds to function and encouraging banks to restructure corporate balance sheet debt with the intention of gradually deleverage over time. This synchronized
action is a very important point of departure in the context of the Sri Lanka inflation-targeting approach, which suffered in the past 5 years with below-par growth rates achieved, and was placed even below the Afghanistan rate of growth of 2.3 pct.