The Central Bank maintains its monetary policy in an increasingly forward looking manner to maintain inflation at low and stable levels in the medium-term, thereby supporting the economy to reach its potential. The recent rupee depreciation is aligned with capital outflows, not the current account, Central Bank Governor Dr. Indrajit Coomaraswamy said.
“Although we do not consider the Exchange rate as an objective of monetary policy conduct, a market-based Exchange rate remains a key instrument to facilitate the inflation targeting framework. 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 (Flexible Inflation Target) framework.
 Dr. Indrajit Coomaraswamy
Pic: Sulochana Gamage
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The FIT framework brings about a qualitative change in the pass-through of the effects of currency depreciation 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 that inflation remains within the targeted range, he said, at the presentation of the ‘Road Map for 2019 and beyond’ held recently in Colombo.
Last year, the Central Bank maintained 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 also had to consider domestic developments, such as depreciation pressure on the currency due to capital outflows, and the widening trade deficit, sub-par economic growth, deceleration in monetary aggregates and credit, moderate levels of inflation, as well as continuing deficit liquidity conditions in the money market.
Due to the reversal of foreign capital flows in view of rising global Interest rates, the country’s ability to finance the current account deficit through financial flows, while strengthening reserves, would be challenging.
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 (FDIs), 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.
Merchandise exports
A significant growth of merchandise exports of at least 10% with annual FDI flows in the range of US dollars 2-3 billion, supported by healthy earnings in the services sector and continuing contributions from (foreign) 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 the World Bank.
This methodology is expected to ensure that foreign reserves are managed to ensure an adequate level of liquidity, a reasonable return in comparison to the benchmarks, and to exploit any active strategies to make an excess return if the market conditions permit.
The Central Bank will introduce a superior alternative USD/Rs. reference rate for the benefit of all stakeholders, including foreign investors.
As inflation-targeting involves managing and anchoring inflation expectations effectively, transparency of Monetary policy, particularly in terms of plans, objectives and decisions, is of utmost importance. Hence, as transparency is achieved through effective communication, as a prospective inflation targeter, the Central Bank is very conscious of the need for a well devised communication strategy.
A number of initiatives has already been taken by us to enhance the communication strategy. We have enhanced the analytical value of the regular monetary policy press releases with the support of the IMF, while maintaining clarity, simplicity and enhancing the forward looking approach.
We have also initiated programs on educating, particularly journalists and other stakeholders, regarding FIT. Several measures are in the pipeline, including the issuing of regular Monetary Policy Reports, which will be developed into Inflation Reports in the future and expanding the public awareness outreach program, which will be implemented during the next two years as set out in the road-map for FIT.
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 for 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 percent from 7.50 percent 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, 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 ups and downs due to various demand and supply shocks stemming from external and domestic fronts.
“Benefitting from prudent and proactive monetary policy measures that were also supported by several macroprudential measures, monetary expansion was contained at desired levels, thereby supporting the maintenance of low levels of inflation during 2018, he said.
Challenges
The Central Bank has an unblemished track record of maintaining single digit inflation continuously for a decade. This also shows the Central Bank’s strong commitment to price stability, which it considers to be of utmost importance to create an enabling environment for the economy to achieve an accelerated trajectory of economic growth, to uplift the standards of living of the people.
The Central Bank will be resolute in preserving this achievement of a low inflation environment irrespective of domestic and international challenges that we may face in the future.
This is the prime reason why the Central Bank has embarked on a mission to upgrade the monetary policy framework to strengthen the Central Bank to deliver sustained price stability amidst a rapidly evolving environment characterised by increased uncertainty.Last year, significant progress was made towards the transition to FIT in terms of initiating amendments to the Monetary Law Act (MLA) to establish a strong Central Bank mandate, building effective fiscal-monetary coordination, and further improving technical and institutional capacity.
“Last year, we highlighted the need and the importance of strengthening the 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.
Hence, as an important step, the approval of the Cabinet of Ministers was obtained on principle to introduce comprehensive amendments to the MLA, particularly in the areas of strengthening Central Bank independence and facilitating the adoption of FIT as the monetary policy framework, in addition to other amendments to improve governance of the Central Bank, strengthen financial sector oversight and also to boost fiscal-monetary coordination.
The Central Bank, assisted by legal experts of 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.
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 and 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 and 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.
“As we have highlighted on many occasions, strong commitment and 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 the 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 reforms to State Owned Enterprises (SOBEs)and reinforce the Medium-Term Debt Management Strategy (MTDS) 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 on jointly by the government and the Central Bank. Hence, the FIT framework needs 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.
Wrong interpretation
“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 practised by Central Banks, and monetising the fiscal deficit through the Central Bank purchasing Treasury Bills issued on behalf of the government.
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. The system captures vital market information from the Call money, the government securities and the Foreign Exchange markets. Daily liquidity estimation was further improved with the implementation of the liquidity reporting system through the CIMM.
A further a policy intervention by way of restricting non-bank primary dealers from participating in OMO auctions was made in the money market, to strengthening the signaling effect of OMO auctions.
Non-bank primary dealers continued to enjoy access to standing facilities and the intra-day liquidity facility. Meanwhile, at the most recent policy rate adjustment, we narrowed down the policy rate corridor to 100 basis points to reduce the volatility in overnight interest rates.
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 transparency in the monetary implementation process.
“The ‘haircut 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 plan to expand money market activities in a comprehensive manner by introducing new instruments such as Interest Rate Swaps (IRS) and non-deliverable forwards (NDF).
To improve the competitiveness of the banking sector, the Central Bank plans to introduce a more cost reflective alternative benchmark Interest rate, which will be based on the marginal cost of banks.