Sri Lanka would need legislative changes for inflation targeting: officials

ECONOMYNEXT – Sri Lanka may require legislative changes to formally move into an ‘inflation targeting’ framework where the Central Bank is steadily building capacity and laying the groundwork, officials said.

Inflation targeting involves the Parliament or the government formally giving an annual price target for the Central Bank to follow, Deputy Governor Nandalal Weerasinghe told members of Sri Lanka’s Foreign Correspondents’ Association.


Inflation targeting also involves an accountability framework, he said.

Sri Lanka has been getting technical advice from the International Monetary Fund and the World Bank, Weerasinghe said.

In the most successful inflation targeting countries such as New Zealand and key reason for its success was to hold the governor of the central bank individually responsible (a type of Key Performance Indicator) and not a monetary policy committee, to avoid any ‘passing of the buck’, according to proponents of the system.

When the Governor faces sacking after inflation goes above say 3.0 percent (or 4.0 or 5.0 percent), central banks are remarkably prompt at raining interest rates in time and avoiding economic bubbles, analysts say.

Accountability frameworks may also involve a governor giving explanation for generating excess inflation.

Transparent Target

A central bank that has a monopoly in money creation through legal tender laws, and is empowered to manipulate interest rates by printing money (a kind of legalised counterfeiting), is the only agency in a country that can generate inflation.





The target chosen is usually consumer price inflation, rather than more opaque and publicly distrusted indicators such as ‘core inflation’, which give no benefit to the people, if what the public actually experience (headline inflation) is soaring.

Sri Lanka’s central bank is now charged with maintaining price and economic stability, which can be interpreted as a dual mandate clouding the objectives of the bank in providing sound money to the people.

Attempts to keep interest rates down to maintain growth can generate credit and economic bubble, and a collapse of either the currency or output or both.

Sri Lanka’s Central Bank is currently planning to generate much more inflation than a more advanced inflation targeting stable economy of around 5 percent or more.

Sri Lanka also targets the exchange rate, at the moment, although maintaining that an ‘external price’ for the rupee has been removed from the monetary law act.

At the moment, in a so-called ‘soft-pegged’ monetary arrangement, Sri Lanka targets interest rates (by printing money) and tries to target the exchange rate to avoid ‘excessive volatility’, the inevitable result of which is frequent balance of payments crises.

The entire Bretton Woods system of soft-pegged exchange rates collapsed in 1971-73 due to the dual anchor phenomenon.

Real Effective Exchange Rate

Sri Lanka is also planning to target a real effective exchange rate (REER) in the belief that a so-called ‘overvalued exchange rate’ may be hindering exports.

A REER is compiled by measuring the nominal depreciation of a currency against a basket of trading partners and adjusting it for inflation. If inflation in Sri Lanka is 10 percent, and trading partners is 5 percent, the rupee is considered ‘overvalued’.

At the moment, the rupee is about 5 percent overvalued based on 5 currency, 10 currency and 24 currency baskets, officials said.

Governor Coomaraswamy said the intention was to keep the index at 100.

US Mercantilists frequently lob false charges that East Asian nations have ‘undervalued’ currencies. At one time, the charge was against Japan, but now it is against China.

Classical economists have said that charges of currency ‘undervaluation’ in East Asia is mostly a Mercantilist fantasy, which is more related to politics than reality. US President Donald Trump came to power claiming China was undervaluing its currency and has since stayed silent.

There are, however, fears that targeting a REER with a high level of inflation compared to trading partners, may doom the rupee into a permanent depreciation-inflation cycle, much like Sri Lanka’s story since the creation of the central bank after independence from British rule.

Balancing Act

But Central Bank Governor Indrajit Coomaraswamy said keeping a tighter inflation target may ‘squeeze’ growth more than is healthy for a developing country like Sri Lanka.

Other than Indonesia and the Philippines, which had weak central banks generating unsound money, other East Asian nations, including Malaysia, China and Taiwan, fixed the exchange rate as an ‘external anchor’ to keep their inflation down, while becoming investment and export powerhouses.

In several East Asia countries like Malaysia and Korea, the currency started to float more actively after the East Asian crisis.

Hong Kong, Macau and Brunei still have currency boards (legislated fixed exchange rates), and Singapore also has a modified currency board with no policy rates.

Weerasinghe said the central bank was steadily building capacity to enter into an inflation targeting framework. These include forecasting inflation and calculating gaps between the potential and actual output.

The central bank has also moved away from targeting monetary supply to a more rate (price)-based system already.

Fiscal Dominance

It is also necessary to insulate the central bank from fiscal dominance, or the pressure from the budgeting process to allow it to conduct independent policy after the target is given.

Weerasinghe said the government’s commitment to steadily lower the budget deficit will remove fiscal dominance.

But other analysts have called for formal legislative changes to remove any possibility of future fiscal dominance such as by removing Treasury representatives from sitting in on monetary policy meetings.

At the moment, Sri Lanka’s finance ministry has virtual veto power over monetary policy decisions, analysts have warned. (Colombo/May21/2017)

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