Sri Lanka trying to stabilize growth and inflation CB says

ECONOMYNEXT – Sri Lanka’s central bank is trying to stabilize growth and inflation under its existing mandate, a top official said as attempts to target a policy rate by printing money while intervening in forex markets at the same time has plunged the country in to another period of balance of payments pressure.

"The mis-understanding that has arisen, is that a lot of people think we want to stabilize the exchange rate and interest rate," Deputy Central Bank Governor Nandalal Weerasinghe told an economic forum in Colombo.

"That is completely the other way around. If you want stable interest rates and exchange rates, the outcome would be we will have very volatile growth, external demand and domestic demand. Volatile growth and volatile inflation.

"That is not our objective. Our mandate is to stabilize growth and inflation."

He said therefore the central bank saw a need to change interest rates and exchange rate to stabilize growth and inflation.

Weerasinghe said about 75 percent of economic activity came from domestic factors and 25 percent from external side and therefore the central bank targeted the interest rate.

"That is why the instrument that we use to control or stabilize growth is the interest rate," he said.

"We have allowed the exchange rate to be flexible to stabilize external demand."

Sri Lanka’s central bank however collects forex reserves under an International Monetary Fund and a longstanding practice of appropriating reserves to pay state loans, leading to questions about the ‘flexible exchange rate,’ which may be backed by contradictory policy leading to external instability.

A free floating exchange rate regime, where the interest rate is fixed (targeted), based on an inflation index (domestic anchor) and the exchange rate floats do not lead to balance of payments crises or generate a need for capital or exchange controls.





A currency board or hard peg where the exchange rate is fixed (targeted) and the interest rates free float, is also free of balance of payments crises and has free trade and free capital mobility.

Concerns have been raised that Sri Lanka’s current monetary framework has shifting or dual anchors, with contradictory policy, making balance of payments crises inevitable.

The ‘flexible exchange rate’ critics say has turned out to be an unusually unstable soft-peg where the anchor swings suddenly from de facto external (reserve collecting peg) with a convertibility undertaking loosely defined in terms of a real effective exchange rate index and volatility (preventing disorderly adjustment), to supposedly domestic (floating rate with a wide inflation target – 8.1-pct for September under an IMF deal) with unsterilized liquidity collected from the pegged period intact, sending the rupee sliding down.

The interventions to prevent disorderly adjustment then creates liquidity shortages which are filled with printed money to maintain a policy rate, which then creates more external demand, as predicted by classical economists.

At the last policy meeting the central bank cut the reserve ratio to release what and official said was an estimated 90 billion rupees of money deposited in the central bank to fill (sterilize) liquidity shortages raising concerns.

Steep rises in inflation also follow each balance of payments crisis, lowering living standards.

In the face of balance of payments crises that are coming in quick succession, there have been calls for reform of the central bank’s operations and mandate generating a debate.

There are attempts to create a modified inflation targeting framework.

Economists and analysts have called for the central bank to be abolished and a currency board (hard peg) to be established or the country be dollarized, so that balance of payments problems are eliminated and the central bank can no longer practice contradictory policy.

Weerasinghe said that countries like Singapore and Hong Kong used the exchange rate as a tool because they had large external sectors measured in terms of 200 or 300 percent of the economy, while Sri Lanka had a more domestic oriented economy.

Sri Lanka was plunged into a political crisis on October 26 when President Maithripala Sirisena appointed Mahinda Rajapaksa as Prime Minister, adding to uncertainty.

In the past few weeks there have been warnings from both sides of the political divide that Sri Lanka may be on a Latin American path where soft-pegs combined with foreign commercial borrowings have led to severe economic crises.

Sri Lanka started to slap exchange and trade controls shortly after breaking a currency board to set up a money printing (interest rate controlling) central bank in 1950, a phenomenon related to contradictory policy that economists call the impossible trinity of monetary policy objectives.

Sri Lanka has recently slapped controls on cars and gold.

Hong Kong built a currency board in 1983 at 7.8 to the US dollar which did not break even during the East Asian crisis. Singapore and Malaysia also had a currency board under British rule which was maintained during the Bretton Woods period at 3.0 to the US dollar.

Singapore’s currency board was later modified and it currency is now about 1.2 to the US dollar. Sri Lanka’s rupee has fallen from 4.76 to the US dollar in 1950 to 180 to the US dollar now.

Weerasinghe said there are media reports that the rupee is at a historic low, but the rupee has been at historic lows in most years and it was . (Colombo/Dec03/2018)

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