4th March 2001

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The power crisis

Five years ago the country faced a severe power shortage caused mainly by drought conditions. The 1996 power crisis was a strong signal that the country could no longer rely on hydro generation of power alone. A number of studies pointed out that alternate sources of energy were absolutely necessary. Two facts made that very clear.

First the power requirements of the country were growing at a higher rate each year. It was increasing at about 10 per cent per year. Second, the country had reached a near saturation in large-scale hydro-electricity generation. There was therefore an urgent need to find alternate avenues of electricity generation. This did not happen for a variety of reasons.

The least cost methods of generating electricity to meet the increasing domestic and industrial uses had to be explored fast. In fact the glaring situation of a shortage of power should have resulted in the preparation of a long-term plan with short-term goals to avert annual power shortages. There were some efforts soon after the crisis, but a number of power projects that were expected to be commissioned never got underway.

Several international bidders for power projects were disgusted with the abandonment of the proposed projects. Five years after the 1996 power crisis we remain with the problem unresolved. We are about to face a severe crisis soon.

The danger at the moment is that the focus of the power crisis may shift to the issues of corruption; of who was neglectful and responsible for the required power plants not being installed; what political interference retarded progress on the power projects and the vested interests of officials in the projects.

Such a shift in focus at this stage could result in the urgent actions that have to be taken being delayed further. We may move from a crisis to a catastrophe. This is especially so as the new generation of power would take several years and delays might mean that by the time some of the proposed power plants come into operation demand would have outstripped the capacity of these plants.

Misconduct, irresponsibility and corruption, if any, should be investigated These should be thoroughly investigated and appropriate punishments should be meted out. But the accusations of corruption, ineptitude and political interference should not distract from immediate meaningful actions for ensuring a speedy and economical enhancement of power generation. In fact the accusations currently levelled and the fact that in the last five years we have been unable to enhance our power potential adequately demands a new approach to the resolution of the problem.

There are two factors that have impeded the progress of power generation. First the power projects involve large sums of money. This results in avenues for corruption and vested interests. The second is the environmental lobby. There is no doubt that we must ensure that the manner we generate the electricity does not degrade the environment excessively. We must explore solutions to the energy crisis, which are least adverse in their environmental effects. No doubt most of the economical methods of power generation would have some damage to the environment.

The only practical approach is to find a balance between the developmental needs and the environmental concerns. There must be a genuine effort to balance these needs, as they are both in the long-term national interests of the country.

The crisis we face is too serious to leave it in the hands of those who have failed in the last five years. A new institutional mechanism has to be found to ensure speedy implementation of power plants. It is perhaps necessary to establish an Energy Council composed of knowledgeable but disinterested persons to chart a plan for energy and be entrusted with the task of commissioning the needed projects. It should be an apex body with authority to formulate the energy policy for the next decade or so. It should have the authority to implement the programmes as well.

The power crisis is one that requires an immediate plan of action. We have delayed long enough to make the next few years one of anxiety. High costs of electricity could cripple our industries and our export potential and drag down our economic growth. Immediate implementation of power projects is imperative.

Rupee: floating or sinking?

Political observers, pro fessional economists, market participants and, above all, the general public were taken by complete surprise by the Central Bank announcement in January on the free float and the responses were instantaneous and wide ranging. The majority view, from what appeared in media was that while it may be a step toward further market orientation of the economic system, the timing was certainly not appropriate. Given the negative perception of the economy at the current moment and the large fiscal and current account deficits, many felt that there would be a free fall of the currency until it finds its new equilibrium in the foreign exchange market, resulting in a significant depreciation of the rupee.

At a seminar organized by the Central Bank on February 15 on the "floating of the rupee since 1978", Dr. A. Bandara, a senior bank economist said that "Sri Lanka was compelled and there was no option but to adopt a free market". He further noted that the "reason is we were losing reserves at a rapid rate. In 1999 we lost about 18% of the gross reserves and in the year 2000 we lost about 37% of gross reserves." So according to Dr. Bandara, there was no way out for the Central Bank but to go for a free float to come to terms with the acute foreign exchange problem the country is facing.

Dr.D.S.Wijesinghe, another Central Bank economist and deputy director of Economic Research, writing to a newspaper on the subject "Exchange Rate Policy in Sri Lanka", has enunciated the same view. Explaining the working of the crawling band (under the managed float) he has said that ''the system operated quite well for a long period and the Bank widened the spread between its buying and selling rates providing more scope for the market to determine the exchange rate. However the problem with a crawling band is that it operates well only when the market rate moves within the band, mainly around its centre. As long as it moves towards the boundary on either side, it becomes more or less similar to maintaining a system of fixed exchange rates.

In particular, when the market is operating at the selling rate of the Central Bank, it becomes unsustainable as the market builds up expectations of a widening of the band. Particularly at a time when there are large payment deficits in the external sector, as well as the fiscal sector, there is a tendency for the market rate move towards the Bank's selling rate even if the band is further widened, making the Bank's buying rate completely ineffective and removing any scope any for build up reserves through purchases in the market."

The views expressed by these two Central Bank economists are a tacit admission of a policy blunder on the part of the Bank with respect to exchange rate management. Recall that until June 2000 the Central Bank conducted its managed float on the basis of a narrow band (1% on either side) and the Central Bank's buying rate (for the US dollar) did not deviate appreciably from the commercial bank buying rate and there was every possibility of the Central Bank being able to purchase foreign exchange from commercial banks to build up of official reserves, at least on occasions when there is a surplus in the foreign exchange market.

The Central Bank beginning June 2000 started widening the band with a view to inducing an accelerated depreciation of the rupee hoping that it would help stem the decline in foreign exchange reserves. The Bank failed to realize that by doing so it was making a bad situation infinitely worse. With the progressive widening of the band, the Central Bank's buying rate (for the US dollar) became totally unrealistic and completely out of line with the commercial banks' buying rate.

Remember, as of January 22, the day before the free float, the Central Bank's buying rate for the US dollar was Rs.77.40 while that of the commercial banks was Rs.84.70.

In such a situation, only an insane commercial banker would have sold dollars to the Central Bank. With this development. the Central Bank's hopes of building on rapidly depleting exchange reserves were completely dashed.

It took 7 months for the Central Bank to realize that it was on the wrong track as far as the exchange rate management was concerned. Apparently, the Bank has not sought the views of either Dr. Bandara or Dr. Wijesinghe on this matter. The Central Bank has attempted to make out that the period from June 2000 to January 2001 was a preparatory period for the launching of the free float. If this is so, it must be considered a very costly operation for the nation as official reserves to the extent of US$600 million were lost during 2000.

Having being caught up in a colossal policy blunder, perhaps one of the worst in the history of the Central Bank, the Bank management had only two options, namely either to return to the managed float with a narrow band (which existed up to June 2000) or go for a free float. Not being willing to eat humble pie, and to save face (and perhaps their skins too) the Bank management opted for the latter, thus throwing to the winds the enormous social costs that. It would endear (which are yet to be realized). Having opted for a free float, the Bank is now building fences around it in order to prevent the exchange rate finding its own level. (We shall return to this later.)

It needs to be recognized that the reason for the rapid depletion of exchange reserves in 2000 was the serious internal imbalance in the economy, due to an attempt on the part of the government to absorb more resources than what is at its disposal, which percolated into an external imbalance. The attempt to correct this imbalance through a depreciation of the exchange rate is similar to amputating the leg of a patient who is suffering from heart ailment. In fact, there was nothing basically wrong with the managed float within a narrow band and the single digit (6.2%) inflation in 2000 ensured that there was no compelling need (from the viewpoint of export competitiveness) for a sharp depreciation of the rupee. Instead of drawing the attention of the Government and the general public to the growing imbalance of the economy, the Central Bank maintained throughout that the economy was in perfect health.

Dr.H.N. Thenuwara, a senior economist of the Bank, speaking at the same seminar referred to above, said that "in a free floating regime, the exchange rate is determined by the market forces. The Central Bank does not intervene in the process. The Central Bank has control over the domestic money supply and it would be used to curb domestic inflation". What Dr. Thenuwara has implied is that in a free float situation the Central Bank does not intervene directly (through controls) to influence the exchange rate but does so only indirectly through its monetary controls. Dr.Thenuwara further said that "exchange rates fluctuate to equate prices across the borders. Deficits in the balance of payments for instance enhances depreciation."

Dr.D.S. Wijesinghe in his article has echoed the same sentiments when he says that "a central bank has to take into account the realistic value of its currency when it manages the exchange rate. However, due to complexities of the system, this has now become a difficult task. Hence, central banks allow the free market mechanism to determine the price of its currency, based on supply and demand forces. Under the present system in Sri Lanka, it is likely that the external value of the rupee be depreciated to a certain extent, enabling the country to adjust its balance of payments deficit."

Basically, what these two economists have said is that under a free float the exchange rate would be determined by forces of supply and demand and that the Central Bank would intervene only indirectly through monetary controls to guide the rate. It is further implied that following the free float the exchange would necessarily depreciate enabling the country to come to terms with its payments problem. This would mean that the exchange rate would depreciate to a point at which exports would to stimulated and imports would be discouraged, so that the value of exports (of goods and services) and capital inflows will exceed the value of imports (of goods and services) and capital out flows, thereby correcting the payments deficit and build up exchange reserves, followed by a possible appreciation of the exchange rate. In fact, in a dramatic turn of events, the Central Bank expects an overall surplus of US$ 100 million in the country's balance of payments in 2001.

One will not question the Central Bank economists' parrot-like exposition of the behaviour of exchange rates under a free float, although many things could happen in between. Indeed many who wrote to the newspapers on the subject, including some former Central Bank economists, argued that the conventional logic is not going to work in Sri Lanka? That however is yet another matter about which we need not split hairs at the present moment.

What is most intriguing and surprising however are some of the comments made by the Governor of the Central Bank, A.S.Jayawardena, made at the seminar referred to above. First, these refer to "certain precautionary measures" that the Central Bank is supposed to have taken following the free float "to ensure orderly conduct of the market". These are:

1. Placing limitations on the working balances of commercial banks to prevent them from engaging in speculative activity.

2. Requirement that export proceeds are brought into the country within a reasonable period. (We understand that the "reasonable period" means 90 days). Penalties are to be imposed on outstanding exports receipts.

3. A 50 per cent rupee deposit when forward contracts are entered into with the commercial banks.

4. Settlement of large import bills outside the market (presumably by way of direct foreign exchange transfers from the Central Bank).

Now what is interesting is none of these restrictions/arrangements is new to Sri Lanka. They were quite in vogue, in some form or the other, during the 1960s and 1970s when the country was experiencing severe foreign exchange difficulties and were part and parcel of inward looking economic policies of that era. They were progressively abandoned since the introduction of free market policies in 1977, the last to go being the export surrender requirements.

They were jettisoned having being considered incompatible with open market economic policies. In fact, one had the impression that they were banished forever as the economy strove to emulate the economic successes of East Asian Tiger economies. It is in this context that one wonders whether we are on a reverse gear once again.

Please turn to page 6

Central Bank reforms - are they necessary?

By Dr. S.S. Colombage

Credit should go to the ex-Governor of the Central Bank, Mr. John Exter for identifying, 51 years ago, (a) price stability, and (b) preservation of the par value of the Ceylon Rupee (exchange rate) as the main objectives of the Central Bank. In order to fulfil these objectives, the Central Bank should have been an independent authority, free of political bias. It is questionable whether the Central Bank has been operating in this manner.

The Central Bank governor, A.S. Jayawardena is reported to have said "the Central Bank would concentrate on maintaining stable prices and a stable financial system, through the conduct of monetary and exchange rate policy and the supervision and regulation of financial institutions" (according to a recent report in the Sunday Times).

The question is whether this is a new vision found by the Central Bank to carry out its mission.

My answer is no.

Maintenance of price and financial stability has remained as the major function of the Central Bank since its inception in August 1950. John Exter, an economist of the Federal Reserve System, U.S.A., who was invited in 1948 to report on the financial and economic conditions of Ceylon had the wisdom to emphasize (a) price stability (stabilization of domestic monetary values); and (b) preservation of the par value of the Ceylon Rupee (exchange rate) as the main objectives of the Central Bank. Mr. Exter's report provided the basis for the Monetary Law Act, No 58 of 1949 that was passed by the Parliament in November 1949. In terms of that Act, the Central Bank was set up in August 1950.

In the first Annual Report of the Monetary Board (chaired by Governor Exter) submitted to the Minister of Finance for the year 1950, it was stressed that price stabilization was the major concern of the Central Bank. The report stated:

"...In addition to the measures taken by the Monetary Board in connection with the organization and commencement of business by the Bank, the major policy measures of the Board were concerned with the problems of inflation.

Consequently, a considerable part of this report is devoted to an analysis of the inflationary situation in Ceylon". (Annual Report of the Monetary Board- 1950, page 1).

So it is clear that the Bank was very much concerned about price stability at the outset. It was mentioned in the newspaper report that "a set of young bank professionals", appointed by the Central Bank to study the bank and make recommendations on its future course, decided after two outstation "retreats" that the Central Bank should focus on the main objectives of price and financial stability.

Is this a path-breaking invention?

One could also raise questions like, "Is this a great finding of some genius young bank professionals?" "Have the Central Bank authorities been ignorant all this time to understand and achieve price and financial stability, as clearly envisaged in the Monetary Law Act, until this young group made their great discovery?" I am of the view that these "young professionals" have merely repeated what Mr. John Exter had stated some 51 years ago.

We should be humble enough to give the honour to John Exter for his foresight to specify maintenance of price and exchange rate stability as the major function of the Central Bank.

The same newspaper report also stated that the re-organization of the Central Bank came as an indirect result of the January 1996 LTTE bombing of the bank's Fort headquarters. "It was at this point (in 1996) that we realized that we had expanded so much over the years that we may be doing things that we should not be actively involved in".

So the Central Bank authorities now seem to consider the bomb blast as a disguised blessing! The general public of this country has the right to ask, "Why did the Central Bank wait for nearly five decades, until the LTTE blasted it, to realize that it had being doing non-central bank functions, and it had grown up excessively?"

In order to fulfil the objectives as envisaged by John Exter, the Central Bank should have been an independent authority. The Central Bank should have the honesty, courage, and strength to express its opinions on monetary and economic issues objectively to the prevailing government, without political interference. The question remains whether the Bank has been operating in this manner. Independence of central banks has been focused widely in recent monetary policy literature.

An advocate of central bank independence, Alan Blinder says "central bank independence means two things: first, that the central bank has freedom to decide how to pursue its goals and, second, that its decisions are very hard for any other branch of government to reverse." (Central Banking in Theory and Practice, 1998). The German central bank, the Bundesbank, is a model for such independent central banking.

In Sri Lanka the Central Bank has deviated from its assigned functions as specified in the Monetary Law Act. Generally, monetary policy objectives and fiscal policy objectives have not been compatible. And very often, monetary policy objectives have been sacrificed to accommodate fiscal requirements in this country.

Such actions have undermined price stability considerations to a large extent. For a central bank to be independent, it should be able to decide (a) its goals, and (b) instruments without political pressure. This does not mean that the goals and instruments of the Central Bank should not be compatible with the broad policy objectives of the government.

What it means is that the Bank should give priority to its primary objectives, mainly price and financial stability.

Our experience amply demonstrates that when the Central Bank is weak, political leaders control not only the goals but also the instruments that belong to the monetary authorities.

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