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Sunday June 13th, 2021

Sri Lanka plans flexible inflation targeting from 2020; monetary law overhaul

ECONOMYNEXT – Sri Lanka’s central bank will move to a flexible inflation targeting framework from 2020, seeking to be free from the task of filling budget deficits with printed money and generate around 4-6 percent inflation a year.

Sri Lanka’s monetary law will be revamped to put more stress on keeping inflation low.

"These amendments would broadly include strengthening the mandate of price stability, separating the monetary and fiscal functions, strengthening the Central Bank’s autonomy, and introducing institutional arrangements for setting inflation targets and maintaining accountability," Central Bank Governor Indrajit Coomaraswamy said presenting a road map for monetary policy in 2018.

In a related move President Maithripala Sirisena had called for the Central Bank Governor and member of the governing monetary board to be appointed by a constitutional council, which may also contribute to its independence.

Sri Lanka operates a notorious soft-dollar peg where its readiness to print money helped politicians deficit spend and generate economic stability almost from the year after it was created, when the first draconian exchange controls were enacted.

Before 1951, there was a currency board in the island, with floating interest rates, which acted as a hard budget constraint.

Because the central bank intervenes in forex markets to keep a peg or ‘smooth out volatility’ while printing money to keep a policy rate target, which are contradictory policies, the country runs into forex shortages and outright balance of payments crisis.

It is not clear whether the 4-6 percent inflation target will give enough wiggle room for the central bank to create balance of payments crises even after 2020, by delaying rate hikes.

The central bank is now fine tuning its inflation forecasting models and developing other analytical tools with technical support from the International Monetary Fund, officials said, ahead of a transition to the ‘flexible’ inflation targeting regime with a ‘flexible’ exchange rate.

A working inflation targeting framework that has been implemented in countries like Australia and New Zealand, requires a true floating rate with no money created with dollar purchases or a foreign reserve collections.

In 2017 Sri Lanka’s central bank collected 1.7 billion US dollars from forex markets, and mopped up the liquidity, and built up forex reserves, clearly showing it is still operating a soft peg.

The new monetary law will end the requirement for the central bank to give interest free ‘provisional advances’ to the Treasury at the beginning of every year up to 10 percent of planned annual revenue.

The provisional advance are one of the most overt evidence of fiscal dominance contained in the deeply flawed monetary law of post – independence Sri Lanka.

Deputy Governor Nandalal Weerasinghe said with a planned liability management law set to allow the government to raise extra funds, such provisions would no longer be necessary.

Analysts say in practice the central bank has in many years mopped up the printed money of its interest free ‘provisional advances’ by through sterilizing operations very quickly to counter the danger to the economy thereby killing domestic private credit in equal measure.

The same effect on credit volumes and interest rate could have been achieved by the Treasury directly borrowing from the domestic market they say,

The central bank also created very high levels of inflation in the 1980s through its ‘re-finance’ of rural credit. The rural credit department used printed money in a Zimbabwe Reserve Bank style operation to give credit in the 1980s.

Governor Indrajit Coomaraswamy said because the central bank had expertise in the area, it had no plans to close the department as the country moved to an inflation targeting regime.

Deputy Governor Weerasinghe said rural credit will not use printed money but only existing revolving credit funds or Treasury money allocate for the purposes.

"There will be no printed money, for rural credit," he told reporters.

The central bank also has other functions such as selling Treasury bonds and managing the Employees Provident Fund which may create conflicts with its monetary policy objectives. (Colombo/Jan04/2018).

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