ISSN: 1391 - 0531
Sunday, August 12, 2007
Vol. 42 - No 11
Columns - The Sunday Times Economic Analysis  

CB losing its credibility and independence

By the Economist

The independence and credibility of the Central Bank is vital for the country’s economic prosperity. It is indeed most unfortunate that the credibility of the Central Bank has come into question recently as it vitiates its role as the apex institution of the financial system. It is the economic adviser to the government; it is responsible for the country’s monetary policy that is so vital to the stability and growth of the economy; and it is the regulator and supervisor of financial institutions whose stability is indeed critical for the smooth functioning of the economy. The weakening credibility of the Central Bank is closely related to the politicisation of the bank over the years. This politicisation has gained momentum in recent years and as a consequence its credibility is at its lowest. As it often happens, when institutions are weakened their capacity to recover their lost stature and respect is most difficult.

The founding fathers of the Central Bank laid down specific provisions to ensure the independence of the Bank. These included provisions to ensure the independence of the Governor. It provided for the term of office of a Governor to be longer than the term of office of Parliament; six years instead of five for Parliament. The Governor of the Central Bank once appointed could not be removed from office during his tenure of office except for three reasons: Corruption, insanity or ill health. And his removal had to be by a vote in Parliament. What better provisions than these to ensure the independence of the Governor. The Monetary Board was to consist of three independent members; the Governor (Chairman), the Secretary to the Treasury (for a long time a civil servant who had independence in career) and an appointed member. Since then the Board has been expanded to reflect developments in the country, especially the private sector and business participation.

Notwithstanding these provisions there has been, at first a gradual erosion of independence and more recently a high degree of politicisation. Many Governors have not lasted the full term of office. They have been eased out by various innovative incentives, like being appointed as executive directors of international financial institutions like the International Monetary Fund or the Asian Development Bank and some through “moral suasion”, a special term for persuasion used as an instrument of monetary policy.

Such provisions to guarantee independence have been provided by other countries as well. The Chairman of the US Federal Reserve Bank, the Governor of the Bank of England and the Governor of the Reserve Bank of India are among those who are guaranteed independence and autonomy. To illustrate this; in the United States, the appointment of the Chairman of the Federal Reserve is not a politicised process. He holds office for twelve years, only a joint act of Congress could remove a chairman of the Federal Reserve Bank. And this has never happened in US history.

This independence is enjoyed not merely in terms of constitutional provisions but in practice as well. Consequently Heads of these Central Banks are highly respected. Their statements on the economy are considered authoritative and accurate. Their integrity is beyond question. Even the President of the United States, the Prime Minister of England or the eminent economist Prime Minister of India, Dr. Manmohan Singh, who was himself a former Governor of the Reserve Bank of India, respect and show deference to statements of Governors. Can we say the same of the situation in our Island home? Reading the newspapers of the last month would give readers the answer to this question. Even the ordinary man is sceptical of the views expressed by the Governor.

Governor Cabraal is unfortunately playing a political role. He is trying his best to convey an optimistic view of the economy. He is overextending himself to generate a feeling of well-being in a context of a deterioration in economic fundamentals, economic hardships faced by people and critical economic indicators signalling danger. In the process he is putting his foot in the mouth. Last week we pointed out the rather foolish comment about the money supply and inflation. The Governor did not appear to know that what matters is not whether the Central Bank has printed new notes but whether the supply of money in circulation has increased. The Governor must surely know that inflation can rise by increasing the speed of transactions (or velocity of transactions) even when money supply is fixed. In real life, inflation takes place when both money supply and its velocity of circulation increase. Has that not happened?

His commitment to say that the economy is doing well whatever is actually happening made him blunder further. It is well-known that the tourist industry is faring badly owing to the security situation, instead of facing up to reality, the Governor says that tourism is not important to the economy as it contributes only 2 per cent to GDP. By the same reckoning paddy cultivation that contributes only 1.2 per cent is even less important, tea production still less important at 1.1 per cent, coconut least insignificant at 0.3 per cent and even fishing contributes only 1.8 percent. Many industries are of no importance. Why? All these contribute less than 2 per cent of GDP. These figures are found on Table 2.1 on page 26 of the colourful and costly Central Bank Annual Report for 2006 that Governor Cabraal released with fanfare at an earlier than usual time.

As we said last week, one has to be sympathetic of the Governor’s predicament, as he is a political appointee who has to say that the government is doing well. So the growth rate is being quoted as indicating the economy is robust and healthy. What is not made clear is that a temporary increase in growth rate is possible by short term monetary injections, but in the medium to long term, that very act will lower future growth by distorting relative prices and making the central bank lose its credibility so that it cannot hope to guide the economy.

What about the other fundamental indicators on which there is a deafening silence? No comments on the excessive fiscal deficit, the wasteful public spending, the increasing domestic and foreign debt and the high and increasing debt servicing costs. Why is the currency depreciating? Isn’t the control of inflation a mirage?

The Central Bank has played a vital role in economic growth and development during the last fifty seven years. It has to play a significant role in the future as well. The founders of the Central Bank envisioned an autonomous and independent role for the Bank that they enshrined in several provisions of the Monetary Law Act. However, the country’s political culture and milieu has made it difficult to retain its autonomy and independence.

The regaining of the independence and the integrity of the Bank would be a difficult task. Yet, assessment of the country’s economic performance on the basis of economic facts and economic theory and practice is a vital need. Without this the Central Bank cannot play its role in promoting economic development. In the past it has been a key figure in institutional building and improvement in institutional capacity in financial institutions and services. Now it is itself weakening its stature and capacity.

Top to the page

Copyright 2007 Wijeya Newspapers Ltd.Colombo. Sri Lanka.