Where is the money?
View(s):After reading my article titled “Time for helicopter money” in this column two weeks ago, a friend of mine sent me a text message. While complimenting the article, he complained: “I would have really enjoyed, and the readers would have also benefitted if you used that theory to explain the present Sri Lankan crisis as well”. 
Well, here I am again on the same issue, but this time attempting to explain the Sri Lankan case. Before getting there, we need to refresh our memories – why is it time for helicopter money?
Initially, the idea of “helicopter money” — money that drops down from the central banks to people’s hands through the country’s banking system — was to establish the theory that “money in excess leads to inflation”. Whether this is true or not under different circumstances, it is an idea that dominates the economic thinking to-date.
Pumping more money
During a time of crisis, we observed two economic realities – On the one hand, there is economic contraction: With paralyzed economic activities people must ultimately face the consequences of the loss of incomes, jobs, and livelihoods. On the other hand, there is no inflationary pressure during such time, but rather the deflationary fear as in many rich countries. If money pumped by the central banks ends up in the hands of people – consumers and producers, they begin to spend more. When they spend more, there would be a revival of economic activities mitigating the loss of incomes, jobs and livelihoods. Since there is no inflationary pressure during crisis times, central banks are in a better position to pump more money anticipating a revival of the economy.
For this theory to work, a fundamental requirement is that money should end up in the hands of people – consumers and producers who would spend more and more helping to revive the economy. Instead, if money ends up in the hands of “speculative investors” in stocks, bonds, gold, oil, and property, and any other toxic asset, then there is no economic revival.
Another possibility is that money would flow out of the country in the form of foreign exchange putting the exchange rate under pressure. In this case capital controls and import controls might come into the scene paving the way for a “controlled economy”. In addition, the central bank must also take detrimental measures to spend foreign exchange reserves to prevent the exchange rate falling.
In the absence of the above possibilities, there is one more: Money that is pumped by the Central Bank returns to it as “excess liquidity” wiping out the hope of an economic revival. This is more a possibility during crisis times than in normal times, because of the increase in the risk of bank lending.
Money that returns
The adverse economic impact of the COVID-19 pandemic issue has come through three channels; (a) the country’s own lockdown, (b) breakdown of the country’s international economic links, and (c) the emerging global economic recession. In the context of economic fallout and lower inflationary expectations, the Central Bank of Sri Lanka has been injecting money through two types of channels during the past few months.
Stacks of new currency notes.
The first was the “Treasury channel” through which the Central Bank has lent to the government Rs. 240 billion by purchasing Treasury Bills from the primary market during the past four months from March – June. Before that, the Central Bank transferred its previous year profits amounting to Rs. 24 billion to the Treasury in February. In total the money supplied to the Treasury was equivalent to 15 per cent of the government’s tax revenue in 2019.
This was the time that the government badly needed money. It had to spend on dealing with the COVID issue on the one hand and, to provide cash subsidies to look after the people who were affected by the lockdown on the other hand. In addition, the government must meet its normal expenditure too, but this time it has to be managed against the loss of tax revenue.
The second was the “banking channel” under which the Central Bank reduced the Statutory Reserve Ratio (SRR) twice releasing Rs. 180 billion to the banks. As per SRR, the licensed banks should maintain reserves out of their deposits at the Central Bank. The Central Bank can use the SRR to release money by reducing it or absorb money by increasing SRR, as and when necessary. First, the SRR was reduced from 5 to 4 per cent in March, resulting in an increase of Rs. 65 billion to the banks. Second, it was reduced to 2 per cent in June, releasing a further Rs. 115 billion to the banks.
In another policy tool at hand, the Central Bank has been reducing its policy rates constantly, which now remains at 4.5 per cent for Standing Deposit Facility (SDF), and 5.5 per cent for Standing Lending Facility (SLF). The banks can deposit their excess money with the Central Bank at the SDF rate and borrow money at the SLF rate.
The additional money that was pumped by reducing SRR was expected to finance credit to affected businesses under the concessionary terms. However, the private credit from the banks seem to have increased only by Rs. 90 billion in the first five months in 2020, which is much below the expectations under the monetary policy stimulus. On the contrary, there was an outcry from the business sector, complaining of difficulties in obtaining bank credit under concessionary terms. The point was confirmed further by the sharp increase in “excess liquidity” in the banking sector which returned to the Central Bank under the SDF. There was already excess liquidity at the beginning of the year amounting to Rs. 40 billion, which increased to Rs. 200 billion by end of June 2020. Why did banks maintain excess liquidity at the Central Bank rather than issuing more credit to the affected businesses?
Fundamental problems
The answer to the question is in two parts: The first part is that it is a “rational choice” for banks to deposit their excess liquidity at the Central Bank under SDF and receive 4.5 per cent interest rather than to go for risky lending. During economic crises, private lending is risky as businesses are going through difficult times, another reason why bank credit on concessionary terms are required, but definitely not at the expense of the banking sector. This is why a credit guarantee scheme is required during crisis times.
A credit guarantee scheme would reduce the bank risks, but nevertheless increase the possibility of non-performing loans. For instance, bank borrowing by public enterprises is usually guaranteed by the government, but it encourages them just to maintain and entertain their status quo. Besides, non-performing loans are naturally on the rise during crisis times so that even a credit guarantee scheme during a crisis time is a difficult choice for either the Treasury or the Central Bank.
The second part of the answer is a more fundamental problem which has ousted many individuals and businesses, as non-eligible customers for formal bank credits. It is not only the inability to provide acceptable collateral, but also the policy and regulatory barriers affecting businesses on the one hand and, the inability to provide accurate and up to-date information on the other hand. For instance, there are 99 countries in the world, performing better than Sri Lanka in terms of the ‘Ease of Doing’ business index in 2019. Furthermore, it is an ICT age, but Sri Lanka has constantly failed to establish centralized information systems, instead adopting digital technology in an ad hoc and piecemeal manner.
When structural weaknesses as such dominate day-to-day business affairs, it is not possible to anticipate mere credit markets to perform efficiently and effectively. We don’t have to wait until we knock our heads in order to realise the gravity of our problems but should have ourselves prepared for uncertain times.
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).