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Sri Lanka to change the way policy interest rates are set: CB Governor

COLOMBO (EconomyNext) – Sri Lanka will change the way interest rates are set, but the emphasis for the time being was on stability, Central Bank Governor Arjuna Mahendran said.

"The policy is to be as market determined as possible," Mahendran told a business forum in Colombo Friday in response to a question on what the exchange rate and interest rate policy would be.

Last week the Central Bank held its 6.5 percent and 8.0 percent policy rate corridor unchanged.

"We have had instances in the past where the way interest rates are set in the country has diverged from what is normally prevalent in other markets," he said without elaborating.

"But of course we did not want to upset the apple cart particularly, ahead of the honourable [finance] minister presenting his budget so we’ve persisted with the earlier regime.

"But we will move up to clean up the way rates are set."

Limited Access

In a previous policy move, the Central Bank effectively cut the policy rate by restricting access to its repo or floor rate window where excess liquidity is deposited, a practice which tends to make market overnight rates fall below the official floor 6.50 percent policy rate to around 5.70 percent.

Sri Lanka has in the past tightened access to its liquidity injection facility -suspected to be a move to by-pass fiscal dominance of monetary policy – pushing market rates up without raising policy rates.

The two rate policy corridor has helped the Sri Lanka in the past, as overnight rates can move up towards the ceiling rate of the corridor through market forces alone – at least 90 basis points – when liquidity tightens up amid credit demand, before an actual policy decision is made to hike rates.

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Inflation and BOP crisis-prone central banks have to be – by definition – late in hiking rates.

Targeting a tight single policy rate can make any contradiction in monetary and exchange rate polices worse and require an actual policy hike decision to stabilize the currency and keep inflation low, analysts say.

The floor rate is active at the moment because Sri Lanka is emerging from a period of excess liquidity built up during weak or negative bank credit that followed the 2011/2012 balance of payments crisis.

Incredible Moves

"The currency itself is obviously subject to what is going on around us," Mahendran said.

"We’ve seen some incredible moves in recent months, around the Swiss Franc, the Singapore dollar, these are pillars of the global economy these two currencies, and they’ve moved so dramatically it will impact our economy in one way or another."

Switzerland has a free floating currency in that it only targets a policy rate, but sometime after the Great Recession its central bank started to effectively peg to the Euro, buying forex, to prevent appreciation.

When the European Central Bank decided to print more money recently the Swiss National Bank let the Swissie go, generating one of the fastest one-day gains ever, though the currency has since fallen.

Singapore has a monetary policy regime that no other country has in the form of a modified currency board.

It’s intra-day liquidity facility is not a true policy rate, and the reserve money supply is always backed by forex reserves making it similar to a curency board, but it diverges from a true currency board in changing the exchange rate target at will in counter-cycle to external – mainly US – generated inflation.

Recently as global commodity prices started to fall signalling an underlying strengthening of the US dollar, the Monetary Authorty of Singapore decided to stop appreciating its currency.

Measured Response

Meanwhile Mahendra said Sri Lanka is examining global developments closely because it did not want to react suddenly but wanted to take a "measured response".

"Our team at the central bank is examining this at the moment in collaboration with their colleagues in other central banks, and the IMF etc, and we will come out with pronouncements on how we see things moving," Mahendran explained.

"But first of all we want to emphasize, stability. Stabilization is our priority. We do not want to upset he markets."

Sri Lanka built a Bretton Woods style soft-pegged central bank in 1950 abolishing an earlier currency board that could not manipulate the interest rates and therefore was unable to generate inflation or balance of payments crises.

A currency board does not have a policy rate but only a fixed exchange rate target.

In trying to target the exchange rate and interest rates simultaneously – a contradictory policy that does not work in the real world which led to the eventual collapse of the Bretton Woods system – the agency has generated repeated balance of payments trouble, high inflation or both since independence from British rule.

Economists also describe the problem as the impossible trinity of monetary policy objectives, where interest rates and exchange rates cannot both be controlled and also allow free movement of capital.

Crisis Prone

The rupee has plunged every time the monetary authority tried to print money and keep rates down when credit demand – usually from the state – went up suddenly, regardless of whether the official price index showed inflation to be low or high.

The last such episode took place in 2011/2012 when it resisted rate hikes when over 200 billion rupees of bank credit was taken to subsidize energy.

The rupee fell from 110 to 130 in the episode and the economic hardships imposed partly helped defeat the last regime.

In the credit collapse that followed the Central Bank built up foreign reserves, but the rupee liquidity generated from more than two billion dollars of purchased dollar inflows were not sterilized permanently.

Analysts had warned earlier that even without any fresh printing of money, when credit started to move, the excess liquidity would hit the balance of payments putting the currency under pressure and reserves would be lost. (Sri Lanka may lose forex reserve beauty contest amid ultra-low interest rates – Bellwether)

Floating or devaluation also does not help as long as excess liquidity is not permanently sterilized analysts say. The remaining excess liquidity would start to move in the form of fresh credit again pressuring the new and weaker rate.

Analysts fear that the unprecedented salary hike to public servants from February is likely to further worsen pressure on the balance of payments when the investible liquidity is borrowed by the state and distributed as wages.

Recast/Updated