Last four articles in this series covered key macroeconomic indicators relating to national production, labour market, fiscal sector and foreign sector and what they reflect on economic development of the country since 1950s. This article outlines key indicators representative of the financial sector.
Financial Markets
Financial markets operate to facilitate demand for and supply of money to cater to economic activities. Markets differ across financial products such as bank credit, Treasuries, private credit, equities and derivatives. As financial products are the various deferred payment terms, i.e., lending products, they involve in risks of defaults and loss of value (purchasing power) between today and future. Therefore, the price of financial products is the interest rate which is the premium paid by the borrower to the lender to compensate for underlying risks and determined by the demand for and supply of respective financial products. Some products such as equities and bonds are traded on prices based on underlying interest rates/yields in markets.
Interest rates and financial prices are largely determined by estimates and speculation on the profitability of underlying real economic/business activities and are highly volatile due to changing set of information/speculations on underlying business activities and the economy. Interest rates/yield rates on government securities (Treasuries) and stock prices are used as broader economic indicators that reflect the movements of financial markets.
Treasuries yields are the benchmarks of lowest risks (sovereign risk) that are used to price private financial products with varying premia to capture respective risks. In developed market economies, the yield curve which is the plot of yield rates across Treasuries of different maturities traded in the secondary market drives other financial markets while financial investments also move between Treasuries and other products. As stocks are the capital used in real businesses, movements of stock price indices in active markets reflect changes in business sentiments in the economy. In developed countries, stock market prices are market signals for macroeconomic economic policies, present and future. However, Sri Lanka does not have an active stock market to reflect business sentiments.
Regulation of Financial Markets
Financial markets are highly regulated through the monetary policy and prudential and consumer protection regulations.
Monetary policy is the regulation on interest rates, exchange rates, credit and liquidity in the economy. Central banks control them to achieve certain targets of employment, production and prices in the economy by influencing on the demand side of the economy. Many central banks use two major policy instruments, i.e., policy interest rates (corridor) and open market operations (OMO). Policy interest rates, i.e., standing deposit facility rate 8% (earlier repo rate) and standing lending facility rate 9% (earlier reverse repo rate) at present, are the minimum and maximum targets for the over-night inter-bank market interest rates. OMO is the injection or absorption of funds/liquidity by central banks in the inter-bank credit market in order to keep the overnight inter-bank interest rates within the central bank’s policy interest rates corridor. In addition, central banks implement bank reserve requirements, credit ceilings/restrictions and sector-specific credit to control the volume of credit and money created and distributed in the economy.
Therefore, levels and movements of interest rates, prices of financial products and monetary/financial liquidity in markets are greatly regulated by the monetary policy changes. The policy transmission affects the supply of credit and money and aggregate demand in the economy. Policy interest rates, Treasuries yield rates, bank credit growth and growth of money supply are used as economic indicators reflective of monetary conditions that interact with the economy.
There are several other regulators for various segments of the financial system such as banks, non-bank financial institutions and stock exchanges. They are expected to keep the market stable by avoiding unhealthy volatilities and asset bubbles. The literature on financial and economic stability shows that the excessive leverage or credit expansion is unhealthy and serves as warning of future financial instabilities. In respect of the economy, the leverage is measured as ratios of money and bank credit to national income (GDP).
Economic Story of Numbers
The conventional set of financial sector indicators outlined below shows that the financial sector is largely determined by the regulatory environment and fiscal front as policy solutions to macroeconomic issues in different times. Therefore, these indicators cannot explain macroeconomic trends during long periods such as decades.
Policy Interest Rates
Policy interest rates have moved in cycles of several years reflecting the tight monetary policy (high interest rates) followed by subsequent relaxation (low interest rates) and vice versa (see Chart 1). As credit ceilings, statutory reserves and open market operations also have also been used, interest rates are not reflective of monetary demand arising from the macroeconomy. The monetary policy is driven by certain controversial ideologies on relationships between money, inflation and economic growth through the demand side of the economy.
Therefore, policy mistakes are frequent. For example, the whole world including the President Trump is blaming the US Federal Reserve on aggressive monetary tightening during the last two years that has caused excessive global currency tensions and stock market sell-offs back to 2008 levels. The levels of policy interest rates in countries have diverse stories. Some example are the negative or zero rates maintained in western countries in the past decade, around 20% in Sri Lanka in 2000, around 18% in early 1980, 8% in early 1990, 3% in late 1992, 6% in 2000 and 0-0.25% in 2008-2015 in the US, 24% in present Turkey and around 60% in present Argentina due to different economic and monetary policy circumstances in respective economies.
However, no economist can establish empirical evidence whether such monetary policies have been successful in stabilizing the economies, other than controversial ideologies and significant volatilities created to financial markets and economies. In most cases, policy mistakes are well clear. This is why the President Donald Trump openly criticizes the present monetary policy of the US Fed.
Treasury bill Yield Rates
Treasury bill yield rates (91 days, 182 days and 364 days) at weekly primary auctions are largely responsive to policy interest rates and government funding requirements. However, these yield rates are not real market rates as the Central Bank heavily intervenes in the market through own purchases outside auctions to prevent the rate hikes when the market liquidity is tight, early redemption of own holdings of bills when the market is liquid and other unpublic arrangements of funds. Therefore, the relationship between the policy interest rates and Treasury bills yield rates are quite irregular although trends are similar (see Chart 1).
For example, yield rates rose faster above the tightened policy interest rates in periods of 2008/09, 2012 and January 2016 to-date while Treasury bill holding of the Central Bank also was raised simultaneously to high levels in order to control market speculations and pressures on yield/interest rates. Therefore, there is a lot of unpublic information and actions behind these rates. As there is no transparent secondary market in government securities, despite being the oldest market, no yield curve is available for the private sector to determine credit risk premium on individual credit.
Monetary Growth
As money stock (M2, i.e., currency and bank deposits held by public) is externally controlled through the monetary policy, its behaviour also follows the monetary policy cycles. Higher growth of money stock is expected to promote economic growth and raise inflation due to easy money and vice versa. However, the growth of money, despite being an essential capital input for production, does not show a clear relationship with the economic growth and inflation (cost of living-based inflation), partly due to monetary policy issues (see Chart 2). As foreign exchange inflow is highly volatile, fluctuations in monetary growth have been driven primarily by bank credit. Since credit is highly regulated, the monetary growth is not reflective of the real credit demand in the economy.
Money/Credit Leverage
The leverage of GDP on both bank money (M2) and bank credit has not increased fast and shows constrained monetary liquidity. The ratio of money to GDP has increased to around 42% in 2017 from 20-25% in 1950s (see Chart 3). The ratio of bank credit to GDP has increased to 39% in 2017 from below 10% in early 1950s. When under-estimation of GDP is considered, there is much space for expansion of money and credit to facilitate real businesses and employment in the country.
New Policy Direction Required
The country cannot fast-track its growth without innovating the financial sector to provide wider access of credit and capital to people in order to improve and mobilize productive resources. In this regard, following points are made.
Relaxed Regulations to Broaden the Credit Pyramid
The present financial sector regulatory mechanism is not pro-development to mobilise productive resources. Instead, it controls credit and money for stability purposes which have never been achieved. Development is dependent on businesses that take risks and innovate production activities. To the extent credit delivery is suppressed by regulations by a set of people on their ideologies, the wider economy is suppressed too.
As monetary economies operate through credit, regulatory mechanism needs to facilitate the financial sector or credit pyramid to develop and deliver credit to wider economic activities with varying risks. Banking, shadow banking, credit markets (government and private) and capital markets are the broader layers of credit pyramid. The use of the banking alone to finance the wider economy and take risks of businesses is highly risky, given its systemic importance to the national monetary and payment system.
In good economic democracy, everybody with productive skills and resources should be provided with the access to credit/money to utilize the opportunities for economic/business activities that generate production, employment and income. Therefore, significant relaxation and coordination of regulations are necessary for market development. The principal behind regulatory innovations/relaxations should be that those who do businesses bear risks and returns while the state is not there to bail-out everybody. The state will have systems to alert on crises and control the damages caused by system failures.
Urgent Need for Sectoral Credit-based Monetary Policy
As the monetary policy is the core/spine of the credit pyramid, it has to be innovated to deliver credit directly to productive sectors such as agriculture, construction, exports and SMEs with a national credit plan as followed in 1980s to target the development of the national economy. Present inter-bank dealings and liquidity-based monetary policy that focuses on the control of unknown inflation is the model copied from western countries with developed markets which is not suitable for Sri Lanka.
The national monetary policy mandated by the Monetary Law Act is primarily the sectoral credit distribution for the development of the economy. The Central Bank has no research whether the present monetary policy model fulfills sectoral credit needs of the economy. Everybody knows the grave scarcity of credit throughout the economy.
As the literature shows, ad-hoc state-sponsored credit schemes implemented through state banks cannot expand the access to credit. Such schemes invariably end up in creation of a set of new defaulters and capital and liquidity problems to those banks due to political reasons. Therefore, the credit delivery has been widened within the national monetary policy framework.
State Master Plan for Financial Sector
It is the constitutional right of the people to see that the state ensures that the operation of the economic system does not result in the concentration of wealth and means of production to the common detriment and the state eliminates economic and social privilege and disparity and the exploitation of man by man and by the state. The access to affordable credit based on skills and ability is an essential means to eliminate disparities and exploitations and to improve privileges.
Therefore, it is urgent that the government now prepares a time-bound master plan to broad-base the credit system for economic development and directs respective state authorities to implement the new financial system fairly soon in one to two years. No credit pyramid/financial system can be efficient and productive without transparency in inter-bank interest rates, yield curve and stock prices that are the benchmarks of different layers of risks to be used for private credit transactions and investments. State economic services should be aligned to utilize the credit pyramid and not to block it.
The issue is whether the government is capable of doing this. Present statutes have the adequate flexibility. However, relevant bureaucracy will prevent such innovations by claiming for new laws as usual as they do not like to change their comfort zones. In that environment, no one can expect the development of the country in next few decades.
(The writer is a former public servant as a Deputy Governor of the CB and a chairman and a member of 6 Public Boards. In his nearly 35 years’ service, he also served as Director of Bank Supervision, Secretary to the Monetary Board and Senior Deputy Governor and authored 5 economics and financial/banking books published by the CB and more than 50 published articles.)
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