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Sri Lanka’s new administration is “serious” about reforming the Central Bank, Deputy Policy Planning and Economic Affairs Minister Harsha de Silva, who is pushing to raise real household incomes, said.

Analysts say real household incomes cannot be raised with a central bank that constantly depreciates the currency, and whose operational practices also weigh heavily against a strong currency.

The Central Bank was placed under the Economic Affairs Ministry by the Sirisena administration, rather than the Finance Ministry.

“Our long term plan is to give central bank full independence and even the separation of the central bank from the ministry of finance and taking it under the ministry of planning and economic affairs in the interim is a signal that we are serious about central bank reforms,” de Silva told EconomyNext.

De Silva is keen to create a social market economy, but the first thing countries like West Germany which practiced such policies did was to fix the Central Bank first.

A depreciating currency destroys the real value of investible capital, lifetime savings of retirees and the sick and also the wages of the currently employed. It is capital that boost labour productivity, improving household incomes.

By destroying domestic purchasing power and household income, currency depreciating countries have only one option left to survive and create jobs – export products to a country that has a stronger currency and consumers with higher living standards.

“We are not going to answering questions on interest rates and exchange rates perhaps as it has in the past, because it is the responsibility of the Governor (of the Central Bank) and his team. It should not be politically motivated,” he said.

The Central Bank also sells debt on behalf of the Treasury and its obligation to keep Treasury interest cost low runs directly counter to the requirement to raise interest rates to keep the currency stable and inflation low.
The Central Bank also manages the Employees Provident Fund which has invested in banks which it regulates as well as other stocks. Analysts also fear that it may give incentive to keep interest rates low and show bigger capital gains.

De Silva told a business forum last Friday that he had been advised that a bill drafted to reform the Central Bank some years ago is still in existence to give more independence to the agency.
“Let them have that (independence),” de Silva said. “In the longer term what the role of the pension funds are and how they will be managed must be looked at because the objectives must be met. Hopefully we will have the answers when we present the next budget.”

Sri Lanka’s Treasury Secretary is still a member of the agency’s rate setting monetary board.
The arrangement which allows the Treasury to veto rate increases, which is necessary to stop printing money when credit demand especially from the state goes up – a process known as fiscal dominance of monetary policy – has been blamed for past high inflation.

But the Central Bank also generates balance of payments crises on its own by delaying interest rate hikes and sterilizing foreign exchange sales with newly created rupees.

Sri Lanka has a failed Bretton Woods style peg, where the monetary authority tries to target both the exchange rate and interest rate at the same time and goes belly-up.

The last such episode was in 2011/2012 when rake hikes were delayed when electricity prices subsidized with bank credit.

Sri Lanka is sharply raising state worker salaries from February and the new regime has also cut fuel prices, which is expected by some analysts to deliver a sharp shock to the credit system.

Balance of payments crises and high inflation is an automatic result of a central bank that fails to hike rates in time.

At the moment Sri Lanka’s rupee is under pressure from excess liquidity in the banking system that is hitting the balance of payments as credit growth exceeds deposit creation in banks.

The Central Bank has been engaging in unsterilized foreign exchange sales – practice which does not generate fresh pressure but actually mops up liquidity – to keep the rupee from depreciating.

The agency has also resorted to its usual tactics of moral suasion to keep the currency up, which has no practical effect other than to scare some dealers.

Analysts say as long as excess liquidity remains, and bank credit is high even a float of the currency will not end pressure, but by mopping up liquidity through the sale of three or preferably six month Central Bank securities can reduce some of the pressure and conserve forex reserves.