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Why Engaging in Commercial Businesses is Taboo for Central Banks

Why Engaging in Commercial Businesses is Taboo for Central Banks

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Published by Thavam

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Published by: Thavam on Oct 07, 2013
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October 7, 2013John Exter to the Central Bank:Don’t engage in commercialbusinesses
The father of the SriLanka’s CentralBank, John Exter,was emphatic on one point when hedrafted the MonetaryLaw Act or MLA,the legislation under which the CentralBank has beenestablished. Going by the traditionalcentral banking principles, in theGeneral Section of the Exter Report, he prohibited the Central Bank to engage in commercial businesses. This prohibition has got into the MLA as Section 117 of the Act in the form of threeseparate sub sections exactly as recommended by Exter.
The Central Bank is not to engage in trade or commercial businessesThe first sub-section says that the Central Bank shall not engage in ‘trade or have anydirect interest in any commercial, industrial or other undertaking’. What this means isthat the Central Bank cannot run, if a very simple example is considered, a dairy farmor own shares of a dairy farm owned by someone else. However, as a practicalmeasure, the Central Bank has been permitted to own a business enterprise if it has toacquire it in the process of recovering any loan it has granted to, say, a commercialbank. But John Exter has advised the Central Bank and it has been provided for inMLA that the Bank should dispose of that enterprise as soon as possible. In other words, the Central Bank should not continue to own business enterprises.
The Central Bank is not to buy shares of commercial banksThe second sub section has prohibited the Central Bank to buy shares of any bank or any company or lend money against the security of such shares owned by someoneelse. Buying shares of banks or other private companies is therefore a taboo for theCentral Bank whether the Bank does it directly in its own name or indirectly by usingthe agencies managed by it.The Central Bank is not to lend against immovable propertyThe third sub section has prohibited the Central Bank to accept immovable property or title documents relating to such property when it grants loans. For instance, if acommercial bank wants to borrow from the Central Bank, it cannot accept the buildingowned by that commercial bank as security. This provision has removed any possibilityof the Central Bank coming to own buildings and real estate when its loans are notrepaid by the respective borrowers. It then follows that the Bank should not buy or construct unnecessary buildings or invest in real estate.Follow the spirit and not the letter of the lawThese three prohibitions imposed on the Central Bank should be followed by it in thespirit of the law and not to its letter. What it means is that the Central Bank should notseek to circumvent these prohibitions by owning banks, company shares or businessenterprises indirectly through some of its agencies thereby claiming that it is not theCentral Bank which owns them but some other agency. In other words, the Bankshould not own businesses or banks either directly or indirectly.These prohibitions are universalThese types of prohibitions have been imposed on central banks in general by thelegislations under which they have been set up. MLA in Sri Lanka was enacted in 1949and one may argue that the world has changed significantly since then making suchprohibitions irrelevant or unnecessary in the current context. But that is not the case.For instance, the new Nepal Rastra Bank Act which was enacted in 2012 too has thesame three prohibitions imposed on it by Section 7 of the Act in a special section titled“Functions not to be carried out by the Bank”. Similarly the Royal Monetary Authority of Bhutan Act, enacted in 2010, makes the same prohibitions in Section 11 of the Act withthe special provision that RMA should not do so either directly or indirectly. Hence,these provisions are universal and have validity for all the time.There are valid reasons why central banks should not engagein commercial businesses either directly or indirectly.Central banks create money just by book entriesIn the first place, unlike other businesses in an economy,
central banks get their money for investment in commercial businesses not by hardwork and sacrifice but by just resorting to very easy-to-make double entry bookentries. As explained in the Principles of Central Banking Number four published inthis series previously (available at http://www.ft.lk/2013/09/23/should-central-banks-make-profits/), central banks just make money by debiting an asset account andcrediting a liability account. For instance, if a central bank wants to buy shares of dairyfarm, all it has to do is to create an account called share investments in a dairy farmand debit that account by the value of the shares. To complete the double entry, it willcredit the bank with which the dairy farm maintains its account. When the commercialbank concerned withdraws money to pay the dairy farm, it will ultimately end up ascurrency issued by the central bank which in the common parlance is known as‘money printing’ by the central bank. Thus, a central bank can invest money in acommercial enterprise just by increasing its assets as well as liabilities at the sametime. All others have to make sacrifices to earn moneyThis is indeed a miraculous activity. A private citizen cannot perform such a miracle. If he wants to buy shares of a dairy farm, first of all he has to save some money out of his income by cutting down his consumption. To earn income, he has to either offer hislabour in the market or sell some of the properties he has acquired in the past. Bothare sacrifices. Or else, he has to borrow money from someone to buy shares. But itmeans that he has to make a sacrifice in the future when he has to repay that loan bycutting his consumption at that time. Then, refraining from consumption either today or on a future date is another sacrifice. Hence, it is only through sacrifices that a privatecitizen can buy shares of a dairy farm.Central banks don’t make sacrifices A central bank does not have to make a similar sacrifice either today or on a futuredate if it creates money to buy shares of a dairy farm. In fact, in the current period, itmakes a profit by creating money which is the difference between the face value of themoney it creates and the actual cost of creating that money. For instance, if a centralbank creates a One Thousand Rupee note, it can buy shares of a dairy farm to thatvalue. But it does not spend Rs 1000 to create that note. Its cost is the cost it pays tothe currency printer and the fraction of the cost attributable to that currency note in therunning of the bank. Assume that that cost is just Rs 15. In this situation, it makes aprofit of Rs 985 by printing a currency note with a face value of Rs 1000. This profit isknown in economics as ‘seigniorage’. Hence, from the point of view of a central bank,it is highly profitable to print a currency note with a face value of Rs 1000 just spending

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