The President asked the banks to reduce the interest rates on credits extended to the private sector. In a free market economy, economic agents act on the basis of self interest. Is it in the self interest of the banks to reduce interest rates on their lending? Economists say that what matters is the profit and not the turnover as such. When the price is reduced there will greater demand and if the banks satisfy this extra demand their credit portfolios will expand and so may the profits - though not necessarily so. Some of the loans to the private sector may sour and not be repaid and then the banks have to write them off or at least provide for them thus reducing their profits incurring a larger capital loss than what they would earn as interest.

What matters then to the banks is their assessment of the risks involved in such lending and the general impression now is that the risks have increased in lending to the private sector. This is of course not an argument for maintaining the presently high Average Prime Lending Rates. This is the rate of interest applicable to top borrowers and the risk involved in such lending has hardly changed. Of course the banks must take into account the individual risks of borrowers. But do the banks do this risk assessment on merely subjective factors - the whims and fancies of the managers or on objective factors?

The risk free rate of interest is set by the short term Treasury Bill rates. But the banks have to add a risk premium which may vary according to risk assessment to their lending rates. There are also the taxes imposed by the government and the prevalent inflation although it is coming down. They also take into account the expected returns on the investment if it is to fund investment other than on stocks and short term assets. It is a given that the longer the tenure of the loan, greater the risk.

Banks’ Excess Reserves

Our banks have always had excess reserves. The Statutory Reserve Ratio (SRR) was 10% since April 3, 2003. But with the global financial crisis and the attendant economic recession which began to affect our economy after July-August 2008 and worsened after September, recession, the Central Bank reduced this ratio to 9.25% from October 17, 2008 and further reduced it to 7.75 from November 28, 2008. The total bank reserves were falling from August and declined to Rs 92 billion in December 2008 from Rs 113 billion in September. This was due to the net outflow of foreign exchange that took place from September 2008 onwards. But the Excess Reserves increased owing to the reduction in SRR, from Rs 322 billion in November to 530 billion in December 2008. The decline in Reserves will continue as long as there is a net outflow of foreign exchange.

The CB does not pay any interest on Bank Reserves held with it. So lending to the government did not decline and in fact showed increases though not large.  When banks hold excess reserves, they lose interest. Why then do they prefer to accumulate excess reserves rather than use them to expand credit to the private sector by expanding the volume of outstanding loans and investments? They will probably plead that it is due to the higher risks inherent in such lending owing to the global economic recession. They will prefer to invest in Treasury Bills and Bonds. Over 60% of the Treasury securities are held by the banks and 60% of this is held by the Central Bank itself.

So far, this large increase of reserves has had only a small effect on the growth of the money stock as measured by the conventional monetary aggregates, such as M1 and M2. Narrow money increased by a mere 5% and Broad Money by just 2%. Because the publicdemand for cash balances has also risen, the recent increases in the money stock have not given rise to increased prices in general. In fact the bulk of the decline in point to point inflation has occurred because of the decline in the price of oil and food prices in 2008.But if and when the world economy starts growing fast again, then the excess reserves are there to expand lending to the private sector and the government and this would lead to increases in Money Supply.

As matters now stand, by far the greater threat is rapid inflation, notwithstanding the ongoing recession. When the banks begin to feel more comfortable with expanding the volume of their conventional loans and investments, they will have more than Rs500 billion excess reserves on hand to employ for that purpose. The multiplied effect of such a vast amount of lending, as newly created deposits make their way through the fractional-reserve banking system, portends a large increase in the money stock and hence a correspondingly enormous jump in the general price level. As the public responds to the acceleration of inflation by reducing its demand for cash balances, the increased velocity of monetary circulation will contribute to even more rapid price inflation.

So much potential new money is now impounded in the commercial banks’ holdings of excess reserves that it is difficult to see how the CB will be able to stem the flood once the banks begin to transform those excess reserves into normal loans and investments. If the CB  attempts to sell enough government securities to soak up the growing money stock, it will drive down the prices of Treasury securities and hence drive up their yields, increasing the government’s cost of borrowing to finance the huge budget deficits the government will be running because of its various capital and current account commitments. This scenario holds the potential for a complete monetary crackup.

So the CB must note that it cannot go on with the expansionary monetary policies for too long without bringing on another bout of inflation. In fact the declining trend in point to point inflation has been arrested last month. Nor has the Core Inflation Index come down. Monetary expansion is not required since the banks already hold excess reserves.

Our recent growth  rates don’t mean much    

We have had economic growth after 2005 increasing to 7% and in 2006 it was even 7.7%. But has this growth increased consumption and living standards of the people and has it contributed to public welfare? A significant part of the growth in GDP is due to the war. War increased employment in the armed forces. A significant part of the labor frce is employed in the public sector. We don’t have published figures of the numbers employed in the armed forces as distinct from civilian employment. But the total figure of employment in the public sector has increased by over 250,000 in the last three years. It is now 1.25 million. If we consider the labor participation rate of 50% the employable labor force is around 3.5 million. Since another 250,000 is employed overseas the available labor force for productive employment in the private sector is 2 million. Few will disagree that public sector employment is largely unproductive.

War is essentially destructive and can hardly be considered as productive. Unemployment of course has dropped to 5% but of what use is employing people if they don’t contribute to production? Look at the number of soldiers and policemen lining the streets doing nothing productive in the best years of their lives when they should be at least learning skills to be used productively in the curse of their lives. Of course the public sector produces services. But their output cannot be valued a market prices. The same goes for war output.

The Department of Census & Statistics ignores the problem of computing output in the public sector and merely takes the total expenditure on the public sector as equivalent to the value of the output of the public sector. There are similar problems of computation in other countries too but the USA excludes defense expenditure from its computation of Gross Domestic Product. So has the growth in recent years led to an improvement in living standards? The president quoted the dollar equivalent of per capita incomes to show that per capita has increased in dollar terms to $1,969 in 2008 from $1,226 in 2005. But this is not a valid calculation.

It is in the first place a computation in terms of market prices and does not constitute real GDP. Nor does it allow for changes in purchasing power parities in USA and Sri Lanka. The exchange rate is over-valued and is an average of the end of the year figures. If we consider the Real GDP which is Rs 2,312,383 million and divide it by the population of 20 million the per capita real GDP is Rs 105,619 or in terms of dollars by dividing by Rs 113 to the dollar it is only 1,023 dollars.