Will cheap money come back?

“There are lies, damn lies and statistics” goes the hoary old saying. Even if the statistics are valid they must be interpreted correctly. The central bank reported the external trade figures were up 14.4 per cent in the first five months of 2007 from a year earlier. But what is significant is its contribution to the growth rate and the Foreign Exchange Reserves. It is net exports after deducting imports that matter–the balance-of-trade which continues to be a big negative figure. Yes, there is a slight improvement by four per cent compared to the previous year. But what the public would like to know is whether this establishes a new trend. A single swallow does not herald spring. The Bank should publish the trend line for the balance-of-trade while making its comments.

By RMB Senanayake

Next consider the inflation statistics. The point-to-point change in the Cost of Living Index has slightly declined from 3.9 per cent in the previous month to 3.2 per cent last month. But people want to know what has happened to the price level that increased by three per cent over the previous month. Here too what is required is a trend line showing the average of the Cost of Living Index and the point–to point changes. Then the people will understand how the price level is tending to level off rather than mistakenly expect it to come down.

Monetary myopia

Consider another statistic which the central bank uses as its policy target–reserve money which determines the growth of money supply. The bank congratulates itself that it is achieving its quarterly targets for reserve money. But what about the money supply? Has it grown in line with the bank’s target? What’s needed is the money supply figures along with the reserve money figures. Here too the bank should publish the trend lines for both reserve money and the broad money supply. It would be more credible for the bank to publish the weekly average of reserve money rather than only the end-quarter last day figure because the single day figure can be window-dressed in the same way the commercial banks window dress their financial year end balance sheet figures.

Central Bank’s resolve weakening?

Meanwhile the central bank seems to be intent on preventing any further increases in the interest rates perhaps due to pressure from the government and big business. Its resolve to keep money tight will run into demands from bankers and the treasury to keep them liquid. These pressures will have to be handled by the central bank under dark political clouds and an army that wants to push ahead with the conquest of the Wanni and the north.

When the central bank cancelled the last two primary auction bids (accepting only the 3-month treasury-bill bid at 17.45 per cent) and privately placed the 6-month ad 12-month issues with the two state banks and captive institutions, the market took the view that the bank wants to stabilise if not reduce the short-term interest rates. If it were to abandon the market and place T-Bills on tap instead of tender, it would be a retrograde step. It would open the way for an about-turn in its tight money policy, particularly if it were to keep the reverse-repo window open replenishing liquidity at the Standing Facility rate of 12 per cent, which is far below the market rate. It may have to give up its restrictions on access to the Reverse Repurchase window to check volatility but such accommodation should be at the market rate of interest to allow the market to determine the rates without undue fluctuations.

The central bank can conduct monetary policy by changing either the price of money, ie interest rate or the quantity of reserve money. If it targets the reserve money it will have to allow the market to determine the interest rates. If it wants to maintain the reserve money target it should raise the reverse repo rate to the market level. Normally central banks provide liquidity as a lender of last resort at a penal rate which is called the bank rate which is presently 15 per cent. It is self-defeating not to raise the reverse repo rate to the market level.

Impact of high interest rates

Of course there is the larger issue of whether the rise in interest rates will really bring about a reduction in investment or consumption. It works in developed countries where investment is largely by the private sector and consumption is mainly on credit through credit cards and housing loans. But our macro-economic imbalance is caused by the government and government owned business undertakings are oblivious to interest rate changes as they are not bothered about the return on capital.

Most of the private sector is engaged in services rather than manufacturing. Those firms engaged in import and wholesale trade need more and more borrowings to finance their working capital since prices have gone up due to inflation. So their inflation burden has to be accommodated and these firms can pay higher interest rates which they can pass on to their customers by way of higher prices while preserving their profits.

The central bank seems to be using what it calls “moral suasion” but better described as pressure or intimidation according to a banker. The banks cannot defy the central bank in a semi-regimented environment. But such measures merely mean the central bank decides the allocation of credit rather than the market. Those who believe that markets provide the best allocation of resources will disagree with such measures. China relies on direct controls like the reserve requirement. The PBOC–the Central Bank of China raised the reserve ratio five times since July 2006. (IMF Working Paper quoted in the Economist of March 2007.) But that still leaves the banks to decide for themselves.

Seeking to keep nominal interest rates below the rate of inflation is to cheat the savers. In theory a country’s equilibrium interest rate should equal its marginal return on capital. In developed countries this is often taken to mean that interest rates should be roughly the same as the trend rate of growth of GDP in nominal terms. Our nominal GDP growth rate in 2006 was 18.4 per cent. So the present interest rates cannot be considered too high on this criterion.

Compare this with the central bank’s benchmark lending interest rate of 12 per cent in the reverse repo market. It is an obvious advantage for the banks to borrow from the central bank and lend at 18-20 per cent to private customers. If they invest in T-Bills they have a risk-free investment which also gives them a good return. So why subsidise interest on repos? The banks should be forced to mobilise deposits, both savings and fixed deposit, by offering higher interest rates to the public without pampering them to feed the hungry treasury.

The central bank has to decide between its tight money policy and the needs of the treasury for more and more money at low rates of interest. It should keep the present level of interest rates and provide extra liquidity to the two state banks at the market rates in its reverse repo window. The central bank has reached a decisive crossroad–accommodate the Treasury or continue with its tight money policy as inflationary pressure is still strong in the economy and will increase as the government pushes ahead with the war and the reconstruction in the East.

Should inflation be controlled?

The government is concerned about inflation only because of its impact on the cost of living which can lead to popular unrest. But economists say there are several adverse effects of inflation. The effects are analysed as anticipated inflation and unanticipated inflation; and stable rate of inflation or volatile rates of inflation. Since we have had inflation for a long time people have come to expect inflation–‘expectational inflation’ in the words of Milton Friedman. They will adjust their behavior upon their expectations. Trade unions cannot be hoodwinked and they demand compensatory wage increases for their loss of real incomes through inflation. Businessmen also adjust. It is only the poor and the fixed income earners who don’t have any flexibility to adjust.

Inflation allows the government to increase its revenues and spend without nominally increasing taxes. Economists call this an inflation tax which has the advantage of no collection costs. Also no frauds are possible and what is happening is not visible to ordinary folk who can be fobbed off with the explanation that it’s all due to a rise in world market prices. As long as inflation persists, the government will collect and spend a greater proportion of the GDP in real terms without ever having to raise taxes which are unpopular. There is also the advantage to the government that it can inflate the nominal public debt at least the debt in domestic rupees.

 

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