Ajith Nivard Cabraal: Expanding financial services in Sri Lanka
Address by Mr Ajith Nivard Cabraal, Governor of the Central Bank of Sri Lanka, at the
opening of a new branch office in Jaffna by The Hongkong & Shanghai Banking Corporation
Ltd, Jaffna, 11 February 2010.
* * *
My dear friends,
I am delighted to be here in Jaffna today for the opening of a new branch of HSBC, one of
the market leaders in global banking. The history of the HSBC in Sri Lanka could be traced
back to 1884, when it first commenced operations in Colombo. Today, the largest foreign
bank operating in Sri Lanka has moved to Jaffna bringing banking to the doorsteps of people
in the Northern Province. This is indeed a historic milestone.
This development did not happen by chance. It did not take place automatically. With the
liberation of our entire nation in May last year, the Government and the Central Bank have
taken determined efforts to expand financial services, facilitate and stimulate economic
activities, and develop infrastructure in the North and the East. In fact, I have personally
participated at several bank branch openings during the last few months, and our officers
have been following up the progress, and these outcomes are a result of such combined
efforts. Today, I can proudly say that an ever-growing number of financial institutions operate
in the North and that these provide diverse financial services, whilst of course we would be
the first to admit that a lot more needs to be done.
My dear friends, the development and maintenance of essential public infrastructure is an
important ingredient for sustained economic growth and poverty reduction. In particular,
health, education, electricity, housing and efficient water and sanitation services help lay the
groundwork for a productive and healthy population, capable of contributing to sustained
economic growth. We all know that as a result of the long and bloody conflict, the
infrastructure facilities in the North could not be developed as done in the other Provinces. It
is due to that fact that, with a view to fast tracking the development in the North, the
Government has now launched a well-planned, integrated, accelerated development
program titled "Vadakkin Vasantham." Under this program, the Government expects to invest
approximately Rs. 295 billion (US$ 2.7 billion) during the next 3 years, towards rehabilitation
and development activities. This program is expected to cover the rehabilitation of roads and
other transportation infrastructure, the upgrading of electricity for domestic housing and
industry, water supply, agriculture and irrigation infrastructure and the improvement of the
manufacturing framework. The Government also intends to implement a special poverty
reduction program and establish the required social safety net, quickly.
My dear friends, as we all know, the speedy resettlement of the internally displaced people
has also been a top priority for the Government. Towards this goal, many extraordinary
efforts have been taken. Out of the over 300,000 internally displaced persons who were
rescued and had to be temporarily housed in welfare camps, over 217,000 or 72% have
already been resettled. All those from Vavuniya, Mannar, Jaffna, a part of Mulativu and
Killinochchi have now returned to their homes. The others mainly from Mulativu and
Killinochchi are also to be resettled systematically without any undue delay, depending on
the speed at which the de-mining processes take place. This is an outstanding achievement
against all odds, and I believe the successful resettlement is a tribute to the deep
commitment of the Government, the tremendous efforts of our public service and the
dedicated contribution of several international organizations. I am also tempted to mention
that this surprising outcome may have been a pleasant surprise to many who at certain times
expressed the belief that the government may not have had the inclination nor the urgency to
carry out this challenging task so expeditiously.
My dear friends, the Central Bank has also contributed its mite to these normalization
processes. We have, so far, over the past 8 months, granted approvals for the establishment
of more than 90 banking outlets in the Northern Province. We have introduced a Special
Loan Scheme, also titled "Vadakkin Vasantham" to boost the livelihood development of the
people in the North. Under this scheme, an initial sum of Rs. 3,000 million has been
appropriated to be disbursed at a concessionary interest rate of 9% per annum to the eligible
micro, small and medium scale enterprises, through several Participating Financial
Institutions. The repayment period could extend up to 5 years with a grace period of 6
months. I am happy to note that over 9,000 loans amounting to Rs. 1.8 billion have already
been registered with the PFIs and disbursements of over Rs 1 billion has taken place.
My dear friends, the rich resources of the North, including its forests, agricultural land, wet
lands, lagoons and bays provide a solid base for many enterprises. Even during the conflict
period, the Northern Province accounted for 10 percent of the paddy production, 40% of Red
Onions, 10% of Chillies, 14% of Green Gram and 25% of Ground Nuts. These statistics
indicate that there would be many viable income generating activities which could be
promoted to upgrade the livelihood of the people, with the assistance of the banking sector. It
has been estimated that 129,000 fishermen, representing 20 percent of the total number of
fishermen in our country, live in 219 fishing villages in the Northern Province. In the year
2006, the total fish production from the North stood at 25,900 MT, representing 12 percent of
the country's total production. These facts also indicate that the income generating activities
in the fisheries sector too could be developed substantially in the coastal areas with the
provision of appropriate banking facilities, particularly for multi-day boats, fishing gear and
other ancillary needs such as ice plants, and storage facilities.
Over the past several years, the Central Bank has also initiated several credit schemes
applicable throughout the country, aimed at promoting regional development and poverty
alleviation. In particular, work has commenced on a new Poverty Alleviation Micro Finance
Project to cover conflict-affected districts. Approximately 3,000 beneficiary groups with more
than 12,000 low-income families have already been organized within the Jaffna peninsula
under this project. We have also fast-tracked the Agro-Livestock Development Loan scheme,
which is another scheme that could provide increased benefits to this Province.
My dear friends, during the several recent visits that I made to Jaffna, I always made it a
point to meet with the Chambers of Commerce officials, bankers, Teachers, students,
villagers, fishermen and many others. We received many valuable suggestions from them. In
particular, we received too very useful ideas to open a Central Bank's Provincial Office and
to arrange for a Special Northern Regional Development Fund for the Northern Province. I
am glad to announce today that we will implement both such initiatives in the coming months.
My dear friends, I thought it may also be appropriate to use this opportunity to make a
special appeal to the Sri Lankan Tamil Diaspora, living in all parts of the world. The decades
long conflict which sapped our combined energies in various ways, is finally behind us.
Therefore, it is now time for all of us to get together and rebuild our nation, in particular, the
areas that have suffered. We, on our part, are keen to assist the people of the North to
resume normal lives as soon as possible. Towards that outcome, we believe the Diaspora
too could play an active role and become partners in the development process of the North.
They can be an important influence to accelerate investments to these areas and thereby
support the expansion of industrial activity and tourism. Needless to say economic
opportunities in the North are expanding day by day, and I would like to urge overseas Sri
Lankans to take an early look at emerging investment opportunities in these areas,
particularly in the fields of IT, education and real estate development where they can surely
and effectively contribute.
I would also urge the Chambers of Commerce and Industries, and other similar Associations
to consider establishing international institutional frameworks and links, which would pave
the way for two-way interaction between the overseas Sri Lankan community and our local
institutions and businesses. Such relationships could then act as focal points to promote
remittances and investments into the domestic economy, as well.
My dear friends, today, we meet in the midst of a significant change in our country's
economic and political landscape. The end of the decades long conflict has resulted in the
creation of a significant positive impact, not just in the Northern Province, but also in the
entire country. To benefit by this positive outlook, it is crucial that we start new businesses
and expand on-going ventures. In this regard, I am happy to note that the HSBC, which
brands itself as the "World's Local Bank", could now offer both corporate and small
customers a full range of financial products and services. In doing so, they, as well as all
other banks who are doing business in these emerging areas, will face the challenges of
borrowers not possessing long credit histories or not possessing adequate collateral. This
situation will certainly pose challenges, but we would like to urge all bankers that they should
practice innovative cash flow based lending methods at least for 2 to 3 years, and not to be
too constrained by security based lending only. I also urge financial institutions to lend the
money mobilized from the region for the development of this region.
Finally, let me place on record my appreciation of the presence of the High Commissioner of
the UK, Dr. Peter Hayes at this opening ceremony. Your support to this effort would certainly
encourage the business community both here in Jaffna and elsewhere in Sri Lanka, and I
thank you for your gesture. Let me also congratulate HSBC on this auspicious occasion of
opening the first foreign bank branch in Jaffna. The HSBC Bank with its global connections
could now facilitate financial transactions in the North with all parts of the world, while
HSBC's presence in the Jaffna Peninsula from today onwards, would convey an important
signal to the world that tangible progress is being made in post conflict Sri Lanka. I wish Mr
Nick A Nicolaou, his team in Sri Lanka the HSBC and all their customers, especially the ones
in this area, all success.
Thank you.
Lars E O Svensson: Inflation targeting after the financial crisis
Speech by Prof Lars E O Svensson, Deputy Governor of the Sveriges Riksbank, at the
International Research Conference "Challenges to Central Banking in the Context of
Financial Crisis", Mumbai, 12 February 2010.
* * *
I thank Charles Bean, Claes Berg, Alan Blinder, Stephen Cecchetti, Chuck Freedman, Charles Goodhart, Lars
Nyberg, Irma Rosenberg, Hyun Shin, Frank Smets and Staffan Viotti for discussions of these issues. The views
expressed here are my own and not necessarily those of other members of the Riksbank's executive board or of
the Riksbank's staff. Hanna Armelius and Hans Dellmo of the Riksbank's staff contributed to this speech.
As the world economy begins to recover from the financial crisis and the resulting deep
recession of the global economy, there is a lively debate about what caused the crisis and
how the risks of future crises can be reduced. Some blame loose monetary policy for laying
the foundation for the crisis and there is a lively debate about the future of monetary policy
and its relation to financial stability. Here I will discuss the lessons for inflation targeting after
the crisis. My view is that the crisis was not caused by monetary policy but mainly by
regulatory and supervisory failures in combination with some special circumstances.
Ultimately, my main conclusion for monetary policy from the crisis so far is that flexible
inflation targeting, applied in the right way and using all the information about financial factors
that is relevant for the forecast of inflation and resource utilization at any horizon, remains the
best-practice monetary policy before, during, and after the financial crisis. But a better
theoretical, empirical and operational understanding of the role of financial factors in the
transmission mechanism is urgently required and needs much work, work that is already
underway in academia and in central banks.
So I will focus on two particular issues: whether monetary policy caused the crisis and what
the possible lessons for future monetary policy are.1
Best practice before the crisis: Flexible inflation targeting
It is probably not a surprise to hear that I consider flexible inflation targeting the best-practice
monetary policy. The Riksbank and all the other inflation-targeting central banks conduct
flexible inflation targeting rather than strict inflation targeting. Flexible inflation targeting
means that monetary policy aims at stabilizing both inflation around the inflation target and
the real economy, whereas strict inflation targeting aims at stabilizing inflation only, without
regard to the stability of the real economy, what Mervyn King (1997) has described as being
an "inflation nutter". By stabilizing the real economy I mean stabilizing resource utilization
around a normal level, keeping in mind that monetary policy cannot affect the long-term level
of resource utilization.2
Because of the time lags between monetary-policy actions and their effect on inflation and
the real economy, flexible inflation targeting is more effective if it relies on forecasts of
inflation and the real economy. Therefore, flexible inflation targeting can be described as
"forecast targeting": the central bank chooses a policy-rate path so that the forecast of
inflation and resource utilization "looks good." By a forecast that looks good I mean a
forecast for inflation and resource utilization that effectively stabilizes both inflation around
the inflation target and resource utilization around a normal level. In the event of conflicting
objectives, it achieves a reasonable compromise between the stability of inflation and the
stability of resource utilization. Different central banks express this in slightly different words.
The Riksbank has often used the term "well-balanced" monetary policy.3
The forecasts of inflation and the real economy are then conditional on the central bank's
view of the transmission mechanism, an estimate of the current state of the economy and a
forecast of important exogenous variables. The central bank uses all relevant information
that has an impact on the forecast of inflation and the real economy. In this framework, the
central bank takes financial conditions such as credit growth, asset prices, imbalances,
potential asset price bubbles and so on into account only to the extent that they have an
impact on the forecast of inflation and resource utilization. Inflation and resource utilization
are target variables, that is, variables that the central bank tries to stabilize. Financial
conditions are not target variables. Instead, they are only indicators, as they provide
information to the central bank about the state of the economy, the transmission mechanism
and exogenous shocks. Financial conditions then affect policy rates only to the extent that
they have an impact on the forecast of inflation and resource utilization.4
Now, is there any reason to modify this view of monetary policy given the experience of the
financial crisis so far? Let me approach this question by first asking what the causes of the
financial crisis were, whether monetary policy contributed to the crisis, and whether a
different monetary policy was warranted and could have prevented or reduced the size of the
crisis.
The financial crisis was not caused by monetary policy
Many have claimed that excessively easy monetary policy by the Federal Reserve after 2001
helped cause a bubble in house prices in the U.S., a bubble whose inevitable bursting
proved to be a major source of the financial crisis.5 However, as I see it, the crisis was mainly
caused by factors that had very little to do with monetary policy and were mostly due to
background macro conditions, distorted incentives in financial markets, regulatory and
supervisory failures (also when central banks have been responsible for regulation and
supervision), information problems and some specific circumstances, including the U.S.
housing policy to support home ownership for low-income households.6
The macro conditions preceding the crisis included low world real interest rates associated
with global imbalances, as well as the Great Moderation, with a long period of very stable
growth and stable low inflation, which led to a systematic underestimation of risk and very
low risk premia in financial markets. There were distorted incentives for commercial and
investment banks to increase leverage that were made possible by lax regulation and
supervision and the lack of an appropriate bank resolution regime. There were also distorted
3
The idea that inflation targeting implies that the inflation forecast can be seen as an intermediate target was
introduced in King (1994). The term "inflation-forecast targeting" was introduced in Svensson (1997), and the
term "forecast targeting" in Svensson (2005). See Woodford (2007a, b) for more discussion and analysis of
forecast targeting.
4
Several central banks that do not call themselves inflation targeters effectively do conduct flexible inflation
targeting, although they may not be quite as transparent about their inflation target, the role of stability of the
real economy, etc.
5
See, for instance, Taylor (2007).
6
See Bean (2009) for an extensive and excellent discussion of the crisis, including the credit expansion and
housing boom, the macroeconomic antecedents, the distorted incentives, the information problems, the
amplification and propagation of the crisis into the real economy, the policy responses and the lessons for
monetary policy and economics generally. The Bank for International Settlements (2009) provides a more
detailed account of the possible macro- and microeconomic causes of the crisis.
BIS Review 16/2010
incentives to exercise less due diligence in loan origination because of securitisation and to
conduct regulatory arbitrage by setting up off-balance-sheet entities, which for various
specific reasons ended up still effectively remaining on the balance sheet. There were also
distorted incentives for traders and fund managers to take excessive risks because of myopic
and asymmetric remuneration contracts. There were eventually enormous information
problems
in assessing the risks of extremely complex asset-backed securities, and there was
a huge underestimation of the potential for correlated systemic risks. None of these causes
had anything to do with monetary policy, except that monetary policy may have contributed
to the Great Moderation.
Regarding the role of Federal Reserve monetary policy in the crisis, there are two relevant
questions. First, was the low interest rate reasonable given the information available at the
time? Second, could a different monetary policy with higher interest rates have prevented the
crisis? The first question, whether the low interest rate was reasonable given the available
information, is the relevant one when evaluating monetary policy. It is more relevant to
evaluate policy taking into account the information available ex ante to the policymaker rather
than information ex post that was unknown to the policymaker at the time (see Svensson,
2009a, on evaluating monetary policy ex ante and ex post).7 During the period in question,
given the information available, there was a genuine and well-motivated fear of the U.S.
falling into a Japanese-style deflationary liquidity trap, and the optimal policy in such a
situation is a very expansionary monetary policy.8 It may be that, in retrospect, the risk of
deflation was exaggerated, but there was no way to know this ex ante. Hence, I consider the
expansionary policy very appropriate. Adding some ex post evaluation, one can note that it
did not lead ex post to very high inflation or an overheated economy.9
The second question, whether a different monetary policy could have prevented the crisis, is
relevant when assessing to what extent monetary policy can be blamed for causing the
crisis, notwithstanding if it was reasonable from an ex ante perspective. The credit growth
and the housing boom in the U.S. and elsewhere were very powerful. Real interest rates
were low to a large extent because of global imbalances, the global saving glut and
investment shortage. I believe that somewhat higher interest rates would have made little or
no difference. Empirical evidence indicates that only a small portion of house-price increases
can be attributed to monetary policy.10 Bernanke (2010) shows that the recent phenomenon
of a higher share of adjustable-rate mortgages was unlikely to have significantly increased
the sensitivity of house prices to monetary policy. The availability of new, more exotic
mortgage types mattered much more for initial mortgage payments than the level of
shortterm interest rates. In my view, interest rates would probably have had to be raised very high
so as to cause considerable damage to the real economy in order to stop the credit growth
and housing boom.11 That could have thrown the U.S. right into Japanese-style deflation and
eventually a liquidity trap. Certainly, higher interest rates would have had no impact on the
regulatory problems, distorted incentives and information problems mentioned above
(although they could have ended the Great Moderation with a deep recession and
deflation).12
However, going beyond the Fed's actual monetary policy, perhaps it is possible that the
Fed's emphasis on its readiness to relax monetary policy aggressively in the wake of a sharp
fall in asset prices, as expressed by Greenspan (2002) for example, may have induced
expectations of a floor under future asset prices and contributed to the asset-price boom, the
so-called Greenspan put (Miller, Weller and Zhang, 2002). Arguably, this is more of a
communication issue than one of actual policy, and less emphasis on the readiness to clean
up after a sharp fall in asset prices might have been a preferable alternative.
The International Monetary Fund (2009, Chapter 3) has investigated the role of monetary
policy in causing financial crises. A large number of countries and financial crises were
included in the sample. The conclusion is that "the stance of monetary policy has not
generally been a good leading indicator of future house price busts... There is some
association between loose monetary policy and house price rises in the years leading up to
the current crisis in some countries, but loose monetary policy was not the main, systematic
cause of the boom and consequent bust." Further-more, the overall relationship between the
stance of monetary policy and house-price appreciation across countries in the years before
the current crisis is statistically insignificant and economically weak, and monetary policy
differences explain only about 5 percent of the variability in house price appreciation across
countries.13
Lessons for flexible inflation targeting
What conclusions can we draw so far from the financial crisis about the conduct of monetary
policy and any need to modify the framework of flexible inflation targeting? One obvious
conclusion is that price stability is not enough to achieve financial stability (Carney 2009,
White 2006). Good flexible inflation targeting by itself does not achieve financial stability, if
anyone ever believed that. Specific policies and instruments are needed to ensure financial
stability.
Another conclusion is that interest-rate policy is not enough to achieve financial stability.
Other instruments like supervision and regulation, including appropriate bank resolution
regimes, should be the first choice for financial stability. In many countries, the responsibility
for these instruments rests on authorities other than the central bank. Generally, to the extent
financial instability depends on specific distortions, good regulation should aim to attack
these distortions as close to the source as possible. To counter the observed procyclicality of
existing regulation, macro-prudential regulation that is contingent on the business cycle and
financial indicators may need to be introduced to induce better financial stability. Possible
macro-prudential regulation includes variable capital, margin, and equity/loan requirements.
As expressed by Bean (2009), "the best approach is likely to involve a portfolio of
instruments".14
More generally, what is the relation between financial stability and monetary policy? Financial
stability is an important objective of economic policy. A possible definition of financial stability
is a situation when the financial system can fulfil its main functions (of submitting payments,
channelling saving into investment and providing risk sharing) without disturbances that have
significant social costs. I find it helpful to conceptually distinguish financial-stability policy
from monetary policy. Different economic policies and policy areas, such as fiscal policy,
labor market policy, structural policies to improve competition, etc., can be distinguished
according to their objectives, the policy instruments that are suitable for achieving the
objectives, and the authority or authorities controlling the instruments and responsible for
achieving the objectives. Monetary policy in the form of flexible inflation targeting has the
objective of stabilizing both inflation around the inflation target and resource utilization
around a normal level. The suitable instruments are under normal circumstances the policy
rate and communication, including possibly a published policy-rate path and a forecast of
inflation and the real economy. In times of crisis, as we have seen during the current crisis,
other more unconventional instruments can be used, such as fixed-rate lending at longer
maturities, asset purchases and foreign-exchange intervention to prevent currency
appreciation. The authority responsible for monetary policy is typically the central bank.
Financial-stability policy has the objective of maintaining or promoting financial stability. The
available instruments are under normal circumstances supervision, regulation and
financialstability reports with analyses and leading indicators that may provide early warnings of
stability threats. In times of crisis, there are instruments such as lending of last resort,
variable-rate lending at longer maturities, special resolution regimes for financial firms in
trouble, government capital injections and so forth. The responsible authority or authorities
vary across countries. In some countries it is the central bank, in other countries there is a
separate financial supervisory authority, sometimes the responsibility is shared between
different institutions. In Sweden, the Financial Supervisory Authority is responsible for
supervision and regulation, the Riksbank is responsible for lending of last resort to solvent
banks and for promoting a safe and efficient payment system, while the National Debt Office
is responsible for the resolution of failed banks. During times of crisis, these authorities
cooperate closely with the Ministry of Finance.
My point here is that financial-stability policy and monetary policy are quite different, with
different objectives, instruments and responsible authorities, the latter with considerable
differences across countries. This does not mean that there is no inter-action between them.
Financial stability directly affects the financial markets, and financial conditions affect the
transmission mechanism of monetary policy. Problems in financial markets may have a
drastic effect on the real economy, as the current financial crisis has shown. Monetary policy
affects asset prices and balance sheets and can thereby affect financial stability. But the fact
that financial-stability policy and monetary policy are conceptually distinct, with distinct
objectives and distinct suitable instruments, has to be taken into account when considering
the lessons of the financial crisis for monetary policy. In particular, it makes little sense to
extend the mandate of monetary policy to include financial stability.15
What are the specific conclusions for flexible inflation targeting? One important lesson from
the financial crisis is that financial factors may have a very strong and deteriorating effect on
the transmission mechanism, making standard interest-rate policy much less effective. This
motivates more research on how to incorporate financial factors into the standard models of
the transmission mechanism used by central banks. A rapidly-increasing volume of such
research is now being produced by academic and central-bank researchers and presented at
an increasing number of conferences on financial factors and monetary policy. Important and
challenging questions include how potential output and neutral real interest rates are affected
by financial factors and financial distortions (Curdia and Woodford 2009, Walsh 2009), and
what impact financial factors have on the general equilibrium effects of alternative policy-rate
paths on inflation and resource utilization forecasts.16
Even with much better analytical foundations concerning the role of financial factors in the
transmission mechanism, there will of course, as always, be considerable scope for the
application of good judgment in monetary policy.
Another conclusion, which is not new, is that consideration of the impact of financial factors
on the forecast of inflation and resource utilization may require longer forecast horizons.
Several inflation-targeting central banks (including the Bank of England, Norges Bank and
the Riksbank) have for other reasons already extended their forecast horizon from the
previously common two years to three years. There is nothing that in principle prevents an
inflation targeter from considering forecasts beyond a three-year horizon, but in practice
there is usually little information about anything at longer horizons except the tendency to
revert to the long-term average.
What about "leaning against the wind" (as advocated by, for instance, Borio and White, 2003,
and Cecchetti, Genberg and Wadhwani, 2002), the idea that central banks should raise the
interest rate more than what appears to be warranted by inflation and resource utilization to
counter rapid credit growth and rising asset prices? It has sometimes not been quite clear
whether advocates of leaning against the wind mean that credit growth and asset prices
should be considered targets and enter the explicit or implicit loss functions alongside
inflation and resource utilization, or whether they mean that credit growth and asset prices
should still be considered just indicators and are emphasized only because credit growth and
asset prices may have potential negative effects on inflation and resource utilization at a
longer horizon. In the latter case, leaning against the wind is a way to improve the stability of
inflation and resource utilization in the longer run. Then it is completely consistent with
flexible inflation targeting.17
However, in line with the previous discussion, instruments other than interest rates are likely
to be much more effective in avoiding excessive credit growth and asset-price booms, and
should thus be used as a first best alternative. Interest rates that are high enough to have a
noticeable effect on credit growth and asset prices may have strong negative effects on
inflation and resource utilization, and a central bank will probably rarely have sufficient
information about the likely beneficial longer-horizon effects on inflation and resource
utilization for the trade-off to be worthwhile and motivated.18
16
Walsh (2009) points out that when financial factors cause distortions, these distortions will in general introduce
corresponding terms in a loss function for monetary policy that is a second-order approximation to household
welfare. Curdia and Woodford (2009) present a model where the second-order welfare approximation is a
standard quadratic loss function of inflation and the outpu