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Sri Lanka inflation targeting plan could be threatened by fiscal dominance: study

ECONOMYNEXT – Sri Lanka’s plan to move into a so-called flexible inflation targeting regime may be threatened by pressure from the finance ministry, requiring re-defining the relationship between the Treasury and the central bank, a study has warned.

A study by Kishan Abeygunawardana, an economist at the World Bank, found data that tended to show that central bank policy has been made subservient to the finance ministry or budget deficit (known as fiscal dominance) over a long period, though questions were raised whether the monetary law actually permitted it.

"This situation demands reforms to the fiscal-monetary relationship if the monetary authority plans to move into an Inflation Targeting regime," Abeygunawardana’s working paper titled Implementing Inflation Targeting in Sri Lanka: The Fiscal Challenge said.

"It is commendable that the Central Bank of Sri Lanka has publicly taken on the challenge to implement an Inflation Targeting framework in the medium-term."

Abeygunawardana noted that Sri Lanka’s monetary law written by John Exter, a US Federal Reserve official, limited budget financing by printed money (interest free provisional advances) to 10 percent of revenues on a short term basis only.

According to the so-called Exter report that laid the groundwork for Sri Lanka’s central bank to be established it could be inferred that Exter did not intend for the central bank to be a tool to finance the deficit generally through the purchase of Treasury bills.

"Many central banks and national economies have come to grief because Governments have had too easy access to central bank credit," the report said.

"In Ceylon it has been considered wise, at least while the Central Bank is new, to limit the direct access of the Government to Central Bank credit to its short-term, seasonal requirements for funds."

Abeygunawardana says imposing a statutory limit like on total government financing could help improve the independence of the central bank.

Other analysts say Exter would have done better to impose a limit based on the monetary base rather than the budget.





In a pegged country – especially one exposed to significant import export trade – even printing money to the extent of about 10 percent of the monetary base would generate enough imports to de-stabilize the current and lose foreign reserves raising credibility about the peg.

In Sri Lanka, now 10 percent of the estimate revenues is roughly about 30 percent of the monetary base.

Rather than a short term source of financing, the provisional advances have become a permanent accumulating stock, and the central bank also purchases large volumes of Treasury bills from time to time.

Total central bank credit to government rose as much 30 percent of revenues or more during balance of payments crises.

"One inference coming out of this analysis is that the CBSL may have helped the government at difficult times (e.g. 2001 – peak of terrorist activity, 2008/2009 – peak of war, 2011/12 – energy subsidies, balance of payment difficulties)," he notes.

"Interestingly, such assistance was followed by IMF programs/disbursements in response to external sector difficulties and loss of reserves created at least in part by rapid monetary expansion.

"Continued fiscal financing even going over the statutory limits, arguably, is an indication that the CBSL has been subject to fiscal dominance."

Other economists who have studied the nature of so-called soft-pegged currency arrangements and their tendency to lead to BOP crises, have attribute such spikes in domestic asset holdings of central banks to extended sterilized foreign exchange sales (Why currency crises happen?), which is a phenomenon related to ‘fear of floating’ rather than strictly fiscal dominance.

But even sterilizing forex sales can be attributed to a desire on the part of the central bank to keep interest rates of Treasuries from spiking especially in Sri Lanka, either due to pressure on their own volition, analysts say. (Colombo/Dec26/2016)

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