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Wednesday June 23rd, 2021

Sri Lanka to have framework to stop ‘stimulus’ leading to inflation, BOP pressure

ECONOMYNEXT – Sri Lanka has some space for loosening policy amid weak credit growth but care should be taken for a fiscal stimulus not to lead to balance of payments pressure and inflation, Central Bank Governor Indrajit Coomaraswamy had said.

He said the government will unveil a strategy to implement tax cuts “without undermining stability, without leading into a situation where there is overheating in the economy and then balance of payments pressure and there is inflationary pressure.”

Sri Lanka has announced the abolition of a 02 percent domestic cascading sales tax and a cut of value added from 15 to 8 percent as well as some personal income tax in a bid to boost economic activity, with output falling to 1.6 percent in the second quarter.


“If we look at monetary aggregate and we look at credit growth, that seems to be some space for this incremental aggregate demand to come into the system,” Governor Coomaraswamy told reporters.

“But it is extremely important that we are very vigilant and that this fiscal stimulus must be kept in a framework, which does not undermine fiscal sustainability.

“And, even more importantly, it must not undermine debt sustainability. Sri Lanka has never missed a single payment as finances as far as debt obligations are concerned.”

Sri Lanka’s economic growth slowed and bad loans spiked after the rupee collapsed in the wake of liquidity injections made in 2018.

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In Sri Lanka there is a persistent belief, partly fueled by policy makers and Mercantilists, that fiscal deficits lead to ‘excess demand’.

But classical economists have pointed out that while deficits push up interest rates, excess demand comes from central bank purchases of government bonds from the market or directly from the government.

No Extra Demand

Domestically financed deficits simply lead to higher domestic interests and crowding out of private sector.

“No additions to the money supply take place when the savings of the people are claimed by the government to finance its outlays; such operations merely shift moneys from the pockets of the savers into the pockets of the recipients of government disbursements,” explained classical economist B R Shenoy in a 1966 a reform program produced for the then Ceylon government.

When money is printed through bond purchases by the central bank or provisional advances, or commercial bank borrowings are re-financed with central bank windows, excess demand is injected which will spill over to the balance of payments.

The sales to or purchase by,”the Central Bank of Treasury Bills and other Public Debt, either directly from the Government of via the market” will generate new money.

Shenoy pointed out that if the central bank buys bonds using central bank resources or debiting is required reserves, new demand would also be injected.

“The same and result emerges when Public Debt is sold to commercial banks,” he said. “The latter pay for them in Central Bank money held in their reserves and deficit financing, then, causes the issue of such money into circulation.”

Under Keynesian theory, a so-called ‘stimulus’ with government projects – later changed to temporary expiring tax cuts – could boost spending by using excess of savings over investment, provided the brakes cold be applied in time as private credit recovers.

Monetary Instability

In 2018, despite a tight budget, monetary instability was generated through open market operations, rupee dollar swaps of a style used by speculators to attack pegged exchange rates and sterilizing maturing legacy swaps, analysts have pointed out.

After the currency collapsed output has slowed amid falling domestic demand. Bad loans have spiked.

Inflation has risen to around 5 percent, while growth fell, leading to so-called ‘stagflation’.

In 2019, Sri Lanka’s growth is expected to be below 3 percent and inflation could be close to 6 percent, the central bank has said.

Until then Governor A S Jaywardene created primary dealer system and a liquid secondary market for government debt, to conduct open market operations effectively inject large volumes of new money to manipulate the yield curve.

Under Governor Coomaraswamy, a prudential rule dating back to the time Governor Jayewardene which prohibited the central bank from buying long bond and limited it to purchasing bills has also been abolished.

The policy corridor has also been narrowed. At last week’s monetary policy meeting, policy rates were unchanged.

Based on the experience of 2018, large volumes of excess liquidity could be injected by the central bank to keep call money rates below the policy rate set by the monetary board.

Sri Lanka has followed a so-called flexible inflation targeting regime, giving wide discretion for the central bank to cut rates or inject excess liquidity, while also targeting an exchange rate to collect reserves and inject base money. (Colombo/Dec03/2019)

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