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Central Bank Governor Arjuna Mahendran addresses a press conference held at the Central Bank premises last week

Sri Lanka’s central bank is planning to ratchet up quasi-fiscal activities which were in a bid to push rural growth, a practice which has played a key role in the island’s high inflationary past for worsening poverty through currency depreciation and inflation.
“I want to pump credit to the region,” Central Bank Governor Arjuna Mahendran told reporters this week.

“In the next month we are going to come up with a credit plan, talk to every bank and finance company in each of those provinces and then work on a – give them targets – tell them that you have to go for it now – and we will underwrite it with a central bank guarantee.”

Sri Lanka’s Indonesia style ‘crawling peg’ and high inflation where the urban intelligentsia and economists accepted annual depreciation and price rises (a vicious feedback cycle) as an inevitable consequence of ‘growth’ or inflation differentials came partly from central bank re-finance of rural credit.

Nothing Inevitable
As part of structural reforms initiated by then-Governor A S Jayawardene who proved to economists and journalists that there was nothing inevitable about Sri Lanka’s inflation and that the monetary authority was wholly to blame, central bank re-finance was stopped.

Central Bank re-finance is among the worst a quasi-fiscal activity that conflicts with an inflation and stability objectives of a monetary authority.

Under the ousted Rajapaksa regime some re-finance activities were re-started and questions were raised about the beneficiaries of at least one scheme.

Mahendran believes that there is space for the central bank to engage in more quasi-fiscal activities (QFAs) now that inflation has been tamed.

“Hopefully now inflation is a thing of the past, because the war is over,” Mahendran said. “So that inflationary financing at that time – which was undermining the economy you are right, which was going for military spending – that part of it hopefully is over.”
“Rural credit was being heaped on top of inflationary war finance.

That is why the whole thing was unsustainable. So he (Jayewardene) withdrew completely and cut central bank funding of all these re-finance facilities for rural credit.

“But we have to win the peace now. So we have to reach out and go back to the provinces. So it is not a reversal of policies, just that we are adjusting to the time. Now we have the space to do it.”
Mahendran said he had appointed five regional heads as part of efforts to boost rural finance.

Generating Instability
QFAs like Central Bank agricultural re-finance however can be dangerous even for countries at peace. Zimbabwe’s Agricultural Productivity Enhancement Facility (ASPEF) was one of the key factors of the hyper-inflation generated by the Reserve Bank of Zimbabwe.

The country now has near zero inflation with currency competition, with RBZ’s ability to generate inflation fundamentally broken by currency competition.

China gained stability and started building up foreign reserves after reforms to the People of Bank of China ended re-financing of state enterprises in the 1980s, which were strengthened in the early 1990s by Governor Zhu Rongji who later became prime minister.

China’s foreign reserves collapsed from 17.4 billion US dollars in 1984 to 11.5 billion US dollars in 1986 when reforms were made to the PBOC. Now China has trillions of dollars of forex reserves which may or may not be useful.

In order to keep to an inflation target or prevent the exchange rate from falling, any actual re-finance with central bank credit or money printed to given bailout loans gone bad, the Central Bank will have to sterilize and curb the effect of the QFA from the rest of the banking system.

As a result, if inflation is not generated and currency does not fall from Central Bank re-finance credit could be denied including to rural customers (and possibly higher interest rates if breaks are not applied in time as is usual in Sri Lanka) who are not direct recipients of the re-financed credit.

As a result any QFA that does not generate inflation and currency deprecation is also a tax on the rest of society, which should be a fiscal activity.

Agricultural boosting is best done by the Ministry of Agriculture as a fiscal activity and credit guarantees or subsidies are best given by the Treasury, both with parliamentary approval.

Transparency and corruption
The biggest evil of a central bank’s QFAs is that they escape parliamentary scrutiny and reduces transparency.

“QFAs may allow the government to hide what should essentially be considered budgetary activities in the accounts of PFIs,” explains the International Monetary Fund.
“Such QFAs may not receive equivalent legis
lative or parliamentary scrutiny compared to budgetary operations.”

Sri Lanka’s Central Bank is currently under a cloud for another QFA committed during the last regime involving payments to foreign lobby groups.

The deals are only now being revealed and charges of corruption are made, the problem lies in the public and legislators not understanding the danger of central banking and how they operate and how important it is to constrain their activities for the general well-being of the people.

Though there are calls to punish the wrongdoers the solution to prevent corruption is to make structural reforms to the Central Bank to end all QFA’s including management of the Employees Provident Fund and the auctions of public debt.

“Clearly, QFAs ought to be explicitly considered in the formulation of fiscal programs,” says the IMF.

“As a first step, any quantifiable QFAs should be added to the fiscal balance to provide a broader and more appropriate measure of the deficit.

“To the extent possible, these should then be transformed into normal budgetary operations by replacing quasi-fiscal taxes and subsidies with explicit taxes and subsidies.

“While this would bring them out into the open, their distortionary effects on the economy would remain. More fundamental action–namely, structural reform–is required in order to achieve a long-term solution.”

At the moment the central bank is monetizing large volumes of debt at scales not seen since 2004, in the run-up to the Rajapaksa regime coming to power, the currency is sliding and foreign reserves are under pressure.

Overall inflation however is low due to a rise in the US dollar which is pushing the down prices of traded commodities, though core-inflation hit a two year high in September.

(Courtesy: EconomyNext)