The Sri Lankan economy faced heightened challenges in 2018, emanating mainly from the global economic, financial and geo-political developments that adversely affected the external sector said Dr. Governor, Central Bank, Indrajit Coomaraswamy.
Following is an extract of the speed he made at the ‘Road Map: Monetary and Financial Sector Policies for 2019 and Beyond,’ launch.
There were also several domestic challenges. Political uncertainties, especially during the last quarter of the year, amplified challenges to overall macroeconomic stability. Sub-par economic growth continued in 2018 following subdued growth in 2017. Favourable weather conditions supported a rebound in the agriculture sector while the expansion in services activities has been broad-based.
However, industrial activities slowed in 2018 mainly due to the slowdown in the construction sector.
Consumer price inflation remained low in 2018 in spite of temporary ups and downs due to volatile food prices and administrative price adjustments.
In response to the tight monetary policy stance pursued by the Central Bank in the past two years, monetary and credit growth decelerated in 2018 from the higher levels observed in 2016 and 2017. An adequate expansion in domestic credit flows driven by demand from the private sector was witnessed during the year.
Being guided by these developments as well as considering impending risks and challenges, we followed a cautious approach in relation to the monetary policy conduct in 2018. Taking into account the favourable developments in inflation and the inflation outlook, as well as the subdued performance in the real economy, the Central Bank signalled the end of monetary policy tightening that commenced at end 2015, by reducing the upper bound of the policy interest rates corridor in April 2018.
Nevertheless, considering the impact of global developments that affected external sector stability of the economy, the Central Bank maintained a neutral monetary policy stance in the ensuing period.
The sustained high deficits of rupee liquidity in the domestic money market compelled the Central Bank to reduce the Statutory Reserve Ratio (SRR) applicable on all rupee deposits of commercial banks in November 2018, while increasing policy interest rates to neutralise the impact on interest rates due to the permanent liquidity injection arising from the reduction in SRR.
BOP experienced pressure
In the external sector, the growth in export earnings was outpaced by the expansion in import expenditure, although earnings from tourism, workers’ remittances, foreign direct investment (FDI) and debt related inflows to the government helped cushion the balance of payments (BOP) to some extent.
The BOP experienced significant pressure on account of foreign exchange outflows caused by tightening global financial conditions and the strengthening of US dollar in view of monetary policy normalisation, particularly in the United States, as well as the widened trade deficit.
Similar to the pressure that was observed in other emerging market economies, these developments resulted in a sharp depreciation of the Sri Lankan rupee particularly during the second half of the year. The Central Bank intervened in the domestic foreign exchange market at times to prevent disorderly adjustments in the exchange rate, while allowing demand and supply forces of the forex market to determine its level and direction.
The government and the Central Bank introduced several short-term measures to address the pressure in the external sector, although the external sector developments once again highlighted the need for structural reforms to boost the tradable sector, particularly by enhancing merchandise and services exports in the medium to long run.
The external sector was also affected by political instability during the latter part of 2018. Political developments, compounded by concerns regarding fiscal slippage in the lead up to the elections, were significant causal factors in the decisions of all three major rating agencies to downgrade Sri Lanka’s sovereign ratings. This, in turn, negatively affected investor confidence.
Assistance under the EFF
Sri Lanka continued to receive the assistance under the EFF and we received the fifth tranche of the programme in June 2018. We look forward to the successful completion of the IMF EFF programme in 2019. We are optimistic that the staff level agreement reached in principle with the IMF on the fifth review will proceed to the next level.
Although the government continued its efforts towards fiscal consolidation, the performance on the fiscal front was rather mixed in 2018. Lower than expected revenue collection is likely to challenge the achievement of the targeted budget deficit for 2018. However, the primary balance is expected to record a surplus for the second consecutive year in 2018. This would be only the third time since 1955.
As announced in last year’s Road Map, the Central Bank is progressing towards implementing flexible inflation targeting (FIT) as its new monetary policy framework by 2020. We have taken several policy initiatives to facilitate the transition to FIT during 2018.
During 2018, we were also able to implement several policy measures with a view to maintaining a stable financial system with subdued macroprudential concerns, while increasing the resilience of the financial system to global and domestic shocks.
Consolidation will be encouraged both in the banking and non bank sectors through steady increase in capital requirements. Priority will be attached to achieving sustainable structures in both the banking and non bank sectors in an orderly manner. It is our intention to send out the clearest possible signal that there will be no regulatory forbearance.
We also continued to take measures to strengthen the payment and settlement infrastructure in line with our statutory responsibility of developing an efficient and stable national payment and settlement system capable of catering to the country’s growing payment needs.
To promote digital payment mechanisms in the country, a national standard for QR code based payments was introduced during 2018, while progress was made in establishing the National Card Scheme. The Central Bank also continued to perform its currency management function to facilitate smooth transactions in the economy, while taking measures to preserve the quality of currency notes in circulation.
Priority was also attached to strengthen the Central Bank’s agency functions in 2018. Public debt management was carried out in a way that the government’s financing requirements were met at the lowest possible cost with a prudent degree of risk, while aiming to maintain debt sustainability.
There was continued focus on sustaining the transparency and efficiency of the auction system for Government securities as well as on developing a viable medium term debt management strategy. In consultation with government, we also initiated actions to implement liability management exercises on future debt obligations based on the newly enacted Active Liability Management Act (ALMA).
The liberalisation of foreign exchange transactions was advanced with the introduction of the Foreign Exchange Act No. 12 of 2017 (FEA). Procedures for inward capital flows were further simplified and streamlined for smooth transferring of funds for investment, while limits for outward capital flows were enhanced in selected areas giving local investors access to a wider global market.
As a facilitator, the Central Bank continued its development finance and regional development activities during 2018 with the broad aim of enhancing inclusive and balanced economic growth and financial inclusion in the country. Progress was made in formulating the National Financial Inclusion Strategy.
Improving Lanka’s global position
Further, the Central Bank worked towards improving Sri Lanka’s global position with regard to the implementation of Anti-Money Laundering and Countering the Financing of Terrorism regulations and we entered into new MOUs with several government bodies and institutions during 2018. We are working towards Sri Lanka being removed from the Financial Action Task Force’s (FATF) ‘grey list’ by mid 2019.
A number of measures have also been taken in the pursuit of greater accountability and transparency. In particular, following the recommendations of the Presidential Commission of Inquiry to Investigate, Inquire and Report on the Issuance of Treasury Bonds, measures are being taken to strengthen several laws applicable to the Central Bank.
In a challenging global and domestic environment, the Central Bank is steadily improving its policy frameworks to mitigate possible risks and thereby achieve its broad objectives of economic and price stability and financial system stability. Our actions would be effective and yield desired outcomes only if certain conditions are met, especially the commitment of the government to macroeconomic stability.
Consistent, predictable policies needed
Given the prevailing low growth trajectory, growth promoting policies and structural reforms are much needed priorities for the government. This must, however, be done without disrupting the fiscal consolidation process. For this to happen, the enabling environment must be created for the private sector to play a more active role. We need consistent and predictable policies from the government and a more dynamic and entrepreneurial mindset from businesses.
Government’s initiatives aimed at improving the economic and social infrastructure of the country, enhancing productivity, up- scaling skill levels of the labour force as well as expanding domestic production capacity are vital elements to support an accelerated and sustainable level of economic growth, while maintaining a continued low inflation environment.
The Central Bank conducts monetary policy in an increasingly forward looking manner with the aim of maintaining inflation at low and stable levels in the medium term thereby supporting the economy to reach its potential.
In 2018, the Central Bank conducted its monetary policy in a challenging environment with rapidly evolving adverse global conditions as well as several upside and downside risks on the domestic front. New developments in the global economy in the wake of rate hikes in the United States and the economic normalisation in most advanced economies have demanded monetary authorities around the world to adjust their monetary policies accordingly.
The Central Bank of Sri Lanka also had to consider domestic developments, such as the depreciation pressure on the currency due to capital outflows and the widening trade deficit, subpar economic growth, deceleration in monetary aggregates and credit, moderate levels of inflation as well as continuing deficit liquidity conditions in the money market.
The tight monetary policy stance pursued by the Central Bank, since end 2015, by way of raising the Statutory Reserve Ratio (SRR) and policy interest rates yielded the desired outcomes, especially on demand driven inflation and trends in money and credit aggregates compared to 2016 and 2017.
Such developments, in particular, the favourable developments in inflation, inflation outlook and the trends in the monetary sector, in an environment of lackluster growth performance, induced the Central Bank to signal the end of the tightening cycle in early April 2018, by way of reducing the Standing Lending Facility Rate (SLFR) by 25 basis points.
Nevertheless, global economic conditions and the pressure on the exchange rate has compelled the Central Bank to maintain a neutral monetary policy stance since April 2018.
In the conduct of monetary policy, market based policy tools, particularly policy rates and open market operations (OMOs) were widely used, while the SRR was also used as a tool of injecting liquidity to the market on a permanent basis. In view of the large and persistent shortage in rupee liquidity, the Monetary Board decided to reduce SRR applicable on all rupee deposit liabilities of commercial banks to 6.00 per cent from 7.50 per cent in November 2018.
The reduction in SRR released a substantial amount of rupee liquidity to the banking system, which could have led to a reduction in interest rates and excess aggregate demand. Therefore, in order to neutralise the impact of the SRR reduction and maintain its neutral monetary policy stance, the Central Bank raised policy interest rates simultaneously.
Since the announcement of the transition towards FIT, we have broadly maintained low levels of inflation in spite of some occasional upticks and downturns due to various demand and supply shocks stemming from the external and domestic fronts.
As you all know, the Central Bank has an unblemished track record of maintaining single digit inflation continuously for a decade.
This is the prime reason why the Central Bank has embarked on a mission to upgrade the monetary policy framework with a view to strengthening the ability of the Central Bank to deliver sustained price stability amidst a rapidly evolving environment characterised by elevated uncertainty.
During the year 2018, significant progress was made towards the transition to FIT in terms of initiating necessary amendments to the Monetary Law Act (MLA) with a view to establishing a strong Central Bank mandate, building effective fiscal-monetary coordination and further improving technical and institutional capacity.
strong legal mandate essential
Let me elaborate on a few important areas in relation to the progress towards FIT. Last year, we highlighted the need and the importance of strengthening the existing mandate of the Central Bank to perform its key tasks related to price stability. It is widely accepted that a strong legal mandate is an essential prerequisite for the successful adoption of FIT as it is considered the linchpin that holds the entire framework together.
Accordingly, the Central Bank, assisted by legal experts from the International Monetary Fund (IMF), is in the final stages of drafting the revisions to the MLA, which will address long standing concerns, such as the focus on non-core and quasi-fiscal activities, monetary financing as well as limits to Central Bank autonomy by way of clearly demarcating the powers and functions related to monetary policy.
In addition, the remit of price stability will be elevated to the status of the prime objective of the Central Bank. The revised legislation will also facilitate institutional arrangements for setting inflation targets and improvements to monetary operations, as well as macroprudential tools.
These legislative amendments would not only improve the overall focus of the mandate but would also boost the credibility of the Central Bank through an enhanced governance framework and autonomy as well as greater accountability and transparency of the Central Bank. We expect to submit the amended MLA to the Cabinet of Ministers and the Parliament for approval this year.
Another important element in our transition towards FIT is improving the skills, capabilities and capacities of our staff as well as the systems and procedures to establish a solid framework for forward-looking monetary policy conduct.
ocus on devoting resources
Going forward, the Central Bank will focus on devoting resources towards further improving technical capacity and infrastructure, which would help generate timely and reliable model-based projections for macroeconomic analyses. The Central Bank has already planned to launch a number of new surveys and compile an array of new indicators to support monetary policy analysis. We continuously endeavour to improve the existing data collection and compilation efforts.
These include several production trends related early warning indicators, upgraded price indices, extension of PMI surveys to sectors that need focused attention, and several digitalisation initiatives. We are also in the process of further expanding the household sector Inflation Expectations Survey (IES) beyond the Colombo District through the Country-Wide Data Collection System (CWDCS) with the intention of improving its coverage and precision.
As we have highlighted on many occasions, strong commitment and the support from the government is essential towards adopting FIT as the framework for monetary policy. It is heartening to note that the government has recognised FIT as the prospective monetary policy framework for Sri Lanka and it has been adopting policies aimed at fiscal consolidation in the medium to long run. We welcome government’s efforts related to revenue based fiscal consolidation, which is aimed at raising revenues, while rationalising expenditure of the government.
We expect that implementing the new Inland Revenue Act, improving tax administration supported by the full roll-out of the RAMIS system and improving tax compliance will be instrumental in raising revenues.
In addition, introducing measures to rationalise expenditure, strengthen public debt management through the enactment of the Active Liability Management Act, No. 8 of 2018 (ALMA) and introduce required reforms to State Owned Enterprises (SOBEs) as well as reinforce the Medium-Term Debt Management Strategy (MTDS) aiming to contain the exposure of foreign currency liabilities were all encouraging moves by the government.
Similar to other country experiences, the inflation target in the FIT framework is expected to be decided jointly by the government and the Central Bank. Hence, the FIT framework requires these two institutions to work together, as there should be no misalignment between fiscal and monetary policy.
The Central Bank will continue to resort to active OMOs to manage liquidity in the money market, thereby guiding the short-term market interest rate, which is the key operating target to navigate inflation in the targeted range. I wish to emphasise the fact that OMOs are a strategy to manage market liquidity to align short term market interest rates with the policy stance and not a mechanism to print new money by purchasing or holding Treasury bills by the Central Bank as wrongly interpreted by some analysts.
A clear distinction must be made between such OMOs, widely practiced by central banks, and monetising the fiscal deficit through the central bank purchasing Treasury bills issued on behalf of the government.
Further, we have implemented several measures to provide more information to market participants thereby facilitating an efficient price discovery process in the financial markets. The Central Integrated Market Monitor (CIMM) system was introduced, in January 2018. Further, a policy intervention by way of restricting non- bank primary dealers from participating in OMO auctions was made in the money market with a view to strengthening the signaling effect of OMO auctions.
Single policy rate
Looking ahead, we are in the process of exploring the feasibility of a single policy rate instead of the current corridor system to give clearer signals on the interest rates, reduce volatility in the call money rate and increase the transparency in the monetary implementation process. Also, the hair cut policy relating to the pricing of securities will be reviewed in line with international best practices to ensure smooth operations in the money market. We will be looking into expanding money market activities in a comprehensive manner by introducing new instruments such as Interest Rate Swaps (IRS) and non-deliverable forwards (NDF).
In order to improve the competitiveness of the banking sector, the Central Bank is also planning to introduce a more cost reflective alternative benchmark interest rate, which will be based on the marginal cost of banks.
Although we do not consider the exchange rate as an objective of monetary policy conduct, a market-based exchange rate remains key instrument to facilitate the inflation targeting framework. To this end, the Central Bank will continue to follow a more market-based exchange rate system, allowing the exchange rate to act as the shock absorber in the envisaged FIT framework. The FIT framework brings about a qualitative change in the pass-through of the effects of currency deprecation onto the overall rate of inflation. By adopting forward looking and proactive monetary policy formulation, the cost-push effects of depreciation can be countered by managing aggregate demand through interest rate adjustments to ensure inflation remains within the targeted range.
Flexibility in the exchange rate
Being guided by this principle, since September 2015, we have allowed greater flexibility in the exchange rate. However, during 2018, we saw a significant depreciation of the exchange rate amidst global market conditions, particularly with the surge in capital outflows, increased pressure on the current account as well as excessive speculation in the market. During such times, we need to ensure orderly adjustment in markets. Hence it was necessary for the Central Bank to intervene in a prudent manner without sacrificing much of our reserves.
Going forward, the Central Bank will continue to adopt an exchange rate policy, with cautious interventions at times of excessive volatility in the forex market. This policy is also designed to maintain the competitiveness of the exchange rate and support the rebalancing of the current account, thereby supporting a gradual buildup of foreign exchange reserves as an external buffer.
Due to the reversal of foreign capital flows in view of rising global interest rates, the country’s ability in financing the current account deficit through financial flows, while strengthening reserves, would be a challenging task. Without achieving a sustainable deficit in the current account and attracting long term, non-debt creating financial flows in the form of foreign direct investments (FDI), the external sector will remain vulnerable even in the medium and long term. Hence, a rapid boost in exports and FDI should be the priority for policymakers, without which the external sector will remain vulnerable to short term domestic and external shocks.
A significant growth of merchandise exports of at least 10 per cent with annual FDI flows in the range of US dollars 2 to 3 billion, supported by healthy earnings in the services sector and continuing contributions from workers’ remittances are needed to ensure a gradual rebalancing of the current account and a strong financial account. Hence, sustained measures are needed to improve investor confidence to ensure that short term vulnerabilities are not translated into long term structural deficiencies.
Foreign reserve management activities of the Central Bank will continue to be based on a model based Strategic Asset Allocation (SAA) framework, which was developed with the support of the Reserve Advisory and Management Program (RAMP) of World Bank. This methodology is expected to ensure that foreign reserves are managed with the objective of ensuring an adequate level of liquidity, a reasonable return in comparison to the benchmarks and to exploit any active strategies with the view of making an excess return if the market conditions permit.
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