Reform the Central Bank, but dont

erode its independence

Prime Minister wants a more independent Central Bank

Monday, 19 December 2016

Prime Minister Ranil Wickremesinghe, in the economic policy
statement he presented to Parliament in November 2015, pledged
that his Government would make structural changes in the
Central Bank enabling it to engage in their work in a more
independent manner. This was a solemn promise. But the Budget
speech delivered by his Minister of Finance two weeks later did
not mention a word about the Governments wish to restructure
the Central Bank.
The second economic policy statement delivered by the PM
almost one year later in October 2016 too kept a mum about the
promise that had been made in 2015. The Budget 2017,
presented in Parliament in November, too was silent on this

aspect of restructuring the Central Bank, though there were many

proposals in the Budget falling within the legitimate functions
assigned to the Central Bank by Parliament.
The independent analysts, including this writer, saw it as an
attempt by the Ministry of Finance to encroach what has been the
functions of the Central Bank, assigned to it by law, and thereby
erode its independence (available at:
http://www.ft.lk/article/580074/Budget-2017:-Significantimprovement-if-not-marred-by-policy-inconsistencies-andinterference-with-the-Monetary-Board).

Harsh tone of the Minister of Finance: An

indication of plans to erode Central Bank independence?
In this backdrop, the Minister of Finance is reported to have
announced at a public forum on the Budget 2017 that the Central

Bank would be restructured to ensure better execution of its

responsibilities (available at:
http://www.ft.lk/article/580366/Central-Bank-to-undergorestructuring--Ravi-K).
According to the Minister, The Central Bank has failed miserably
on many fronts because the bank has deviated from its
responsibilities under the law and allowed itself to be politicised.
In his view, the Central Bank should confine itself only to its
regulatory and monitoring functions without dabbling in how to
run the country.
Many activities done by the Central Bank are undesirable and by
implication, they have impeded the action taken by the
government to put the economy in the right footing. Hence, along
with the restructuring the Central Bank, all other pertinent
legislations like the Banking Act and the Payments and Settlement
Act would also be revolutionised. The Minister, without giving
further details, has elaborated that the restructuring process
would be spearheaded by both the President and the Prime
Minister, implying that it is an action initiated by the very top of
the Government.
The tone of the Minister implied that the Government was to
reduce the independence of the Central Bank and make it another
department in the Ministry of Finance. If done, this would be a
disaster and would go against the accepted principles of central
banking. The loser at the end would be the Government and the
people of the country.

Legal Eye takes issue with the Minister of Finance

A reader writing under the penname Legal Eye had taken issue
with the Finance Ministers claim that the bank has failed on many
counts on the ground that it is not an institution coming within the

purview of the Ministry of Finance but under the Minister of

Economic Affairs of which the portfolio is held by the Prime
Minister (available at: http://www.ft.lk/article/581362/FinanceMinister-s-statement-that--Central-Bank-has-failed-miserably-onmany-fronts-). Hence, by implication, the initiative for
restructuring the Bank should come from the Minister who is in
charge of the Central Bank.

With respect to the allegation that the Central Bank has been
politicised, the Legal Eye had quoted an instance where the bank

has obviously been guided by political considerations during the

reign of the current administration. Hence, if the Minister of
Finance has a genuine interest in an apolitical Central Bank, it
would not just be an exercise in which the bank is depoliticised of
the previous government elements and repoliticised with the new
government elements.
That is not what society expects of a central bank; it desires to
have a central bank free from political interferences with respect
to its key functions, namely, conducting monetary policy to
sustain price stability and regulating the banking system to
ensure its stability.

Eternal battle between politicians and central banks

However, there is a continuing battle between central banks and
political authorities with regard to how central banks should
behave in their respective countries. The latest such battle has
come to light in the case of the US Federal Reserve Bank. In this
case, the President-elect Donald Trump has vowed to fire the Fed
Chairperson Janet Yellen because her interest rate policy goes
counter to his plan for stimulating the economy with low interest
rates (available at: http://qz.com/860763/janet-yellens-plan-toraise-interest-rates-wednesday-may-re-ignite-trumps-feud-withthe-fed-chair/).
The Trump victory has started to reflate the US economy with all
promises of stimulating packages and big government
expenditure programmes. When the system gets hotter and the
US will have to sacrifice its long term sustainable growth, it is the
responsibility of Janet Yellen to put measures to cool it down. But
those measures are not admired by politicians who just want to
go for only short term objectives. Elsewhere in the world, in
Russia, President Vladimir Putin and in Turkey, Recep Tayyip
Erdogan, have been noted for bullying their central banks for

lowering interest rates when economic realities have been

suggesting the opposite.
In India, a few months ago, the independent monetary policy
taken by Governor Raghuram Rajan provoked a government party
senior politician to question Rajans loyalty to India which led to
an abrupt termination of his career as a central banker. Hence,
true central bankers are not popular among the politicians and Sri
Lanka is not an exception.
PM need not reinvent the wheel to reform the Central
Bank
On many counts, the Central Bank of Sri Lanka has to be reformed
today. In fact, that reform initiative was started during 2000-4
when the bank went through its modernisation phase. A new
Central Banking Act was drafted, with technical assistance from
IMF, replacing the old Monetary Law Act which had several
features that did not go along with modern central banking
practices.
The Government of Prime Minister Ranil Wickremesinghe which
was in power at that time had accepted that the proposed Central
Banking Act should be enacted; not only that, the government
had agreed to introduce a new Banking Act too replacing the old
Banking Act. There too, IMF supported Sri Lanka to draft a new
Banking Act. However, these two legislations could not be
enacted since Parliament was dissolved in mid-2004 calling for a
general election. At that election, a new government was voted to
power. The new government did not think that it was necessary to
implement central banking and the banking sector reforms.
Accordingly, the two draft legislations were shelved and maybe
still dusting at the Central Banks archives. Hence, if the Prime
Minister and the Finance Minister are interested in reforming the
Central Bank and the banking sector, all what they have to do is
to retrieve those two draft legislations and update them to reflect

the current thinking on the subject.

Global evidence says that independent central banks are
better placed to sustain price stability
The Prime Minister has expressed the desire to make the Central
Bank independent in his first economic policy statement. It is a
laudable goal since that is what society expects of a central bank.
Evidence from the rest of the world has shown that when a
central bank is independent in its policy making, it is more
strongly poised to attain its objective of price stability, the desire
of the community.
When a central bank is independent, it can discipline itself by
avoiding overprinting of money, the main causal factor for selffeeding high inflation. It could also take timely action to tighten
monetary policy by way of increases in interest rates if the money
and credit situation is far above what is desired by a wellbalanced economy. When people realise that the central bank
would take necessary action to curtail inflation without being
influenced by those in power, it builds confidence among people
in central banks action which in turn contribute to lower inflation
expectations, a must for long term price stability, as argued by
MIT cum IMF economist Stanley Fischer in a recent lecture titled
Central Bank Independence (available at:
https://www.federalreserve.gov/newsevents/speech/fischer201511
04a.htm).
The best example is provided by Bank of England, according to
Fischer, which was made independent in 1998. In the UK, inflation
fell below 2% per annum after independence for making
monetary policy was granted to the Bank of England. A similar
experience has been encountered by both Australia and New
Zealand after the reserve banks in the respective countries were
made independent in early 1990s.

The Israel born economist Alex Cukierman, in a paper he

published in 2008 in European Journal of Political Economy under
the title Central Bank Independence and Monetary Policy Making
Institutions: Past, Present and Future, has remarked that the
central bank independence has contributed to price stability in
both developing and developed countries. Sri Lankas good
governance government should not ignore these good global
experiences.
Central Bank becoming subservient to the Ministry of Finance in
the past should not be used as a precedent
The Central Bank of Sri Lanka has been criticised in the past on
the ground that it is subservient to the Ministry of Finance. As
such, though it had independence in deciding on monetary policy,
critics had charged that its policies had in reality been dictated by
top officials in the Ministry of Finance. This has been made
possible by the presence of the Secretary to the Ministry of
Finance on the Monetary Board, the policy deciding body of the
Central Bank, with voting powers.
John Exter, the architect of the present Central Bank, had clarified
in the report he submitted to the government on the
establishment of a central bank in Ceylon, known as the Exter
Report, why this arrangement had been made in the structure of
the Central Bank. According to him, it will allow a better
coordination between the government and the Central Bank with
respect to policy by permitting the Minister to make his views
known to the Board through the Secretary to the Ministry of
Finance (p 13).
However, he made a qualification that its effectiveness depended
on the maturity and experience of the people occupying the high
positions in government and in the Central Bank. Thus, the
Secretary to the Ministry of Finance was expected to function as a
conduit between the Minister and the Monetary Board and not as

a super-official steamrolling over its decisions.

But over the years, Exter was defeated by some of the officials
who had occupied the topmost position in the Ministry paving the
way for critics to justify their charge of having a subservient
Central Bank. Hence, any move to make the Central Bank
independent should re-examine whether the Secretary to the
Ministry of Finance should continue to be a vote-carrying member
of the governing board of the Bank.
Hard choice but essential if the country is to become a
rich nation within a generation
This is a hard choice which the Government has to make today. It
will be difficult for a minister of finance to make up his mind to
give full independence to a central bank since he desires to
exercise control over it. Yet, an independent central bank would
help him to attain long term economic growth by stabilising prices
and maintaining macroeconomic stability. Any control over the
central bank by the minister is therefore tantamount to sacrificing
long term economic growth.
But the goal of the Prime Minister, as presented in the economic
policy statements of 2015 and 2016, is to elevate Sri Lanka to the
status of a rich country within a single generation. This would
require the country to attain, as remarked by the Prime Minister in
the second economic policy statement, an average annual
economic growth of more than 7% over the next 30 year period.
Since growth has been volatile in the post-independence period
with an annual average growth rate of just 4.7%, attaining the
minimum needed economic growth continuously is challenging.
That is why it is necessary for the Government to act wisely by
creating ground conditions for a stable macro economy. In a
stable macro economy with price stability firmly placed within the
system, individuals will be free to make long term investments by

taking a long term view of the economy. An independent central

bank is a sine qua non for this goal.

A far-sighted approach is a must

Any far-sighted government would therefore choose to make its
central bank independent of political patronage and influence. It
is the biggest sacrifice which it can make for the sake of people.
Since the present Government is dedicated to establishing a good
governance system in the country, it would not be difficult for the
Prime Minister to make this hard choice, despite the pressure
coming from his Cabinet colleagues to the contrary.

(W.A. Wijewardena, a former Deputy Governor of the Central Bank

of Sri Lanka, can be reached at waw1949@gmail.com.)
Posted by Thavam