Ranee Jayamaha: Recent economic developments, challenges and strategies -
proactive strategies in reducing inflation
Speech by Dr Ranee Jayamaha, Deputy Governor of the Central Bank of Sri Lanka, at the Central
Bank of Sri Lanka, Colombo, 25 May 2007.
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Inflation is a common enemy. Its impact will be felt by every single person in a country. Managing
inflation and reducing inflationary expectations cannot be achieved by the Central Bank of Sri Lanka
(CBSL) alone. It can only be done collectively and with cooperation from all stakeholders.
Who are these critical stakeholders ?
CBSL, the government, banks and financial institutions, fund managers/traders/dealers operating in
various markets, investors both local and foreign households and consumers.
1. Central Bank of Sri Lanka
Given its prime objective of maintaining price stability, CBSL has been proactive in the conduct of
monetary policy, which is the instrument through which this purpose can be achieved. CBSL sets
monetary targets taking into consideration growth prospects of the economy, liquidity requirements
necessary to facilitate growth and inflation at a desired level. The ultimate aim is to keep inflation at
desirable levels and reduce inflationary expectations. CBSL, at its disposal, has a limited number of
instruments to conduct monetary policy. The current framework places greater reliance on
market-based instruments, such as changes to the policy interest rate and conduct of open market
operations.
Accordingly, CBSL has announced its monetary policy strategy and targets at the beginning of 2007.
The upfront announcement of the policy targets indicates the transparency of monetary policy
operations and we believe that it helps to enhance policy effectiveness. More importantly, it helps the
other stakeholders to fall in line with the announced strategy.
2. Government
The fiscal policy should support monetary policy to work effectively. Therefore, government's
commitment to maintain fiscal targets is essential. According to the government's medium term macro
framework enunciated in the fiscal management report 2007, the overall deficit in 2007 will be
contained at around 7.2% of GDP. The Govt. has taken significant steps to enhance revenue through
additional measures such as improvement to tax administration, rationalize current expenditure and
improve its debt management policy. The achievement of the first quarter 2007 revenue target is
commendable. While maintaining the momentum in revenue targets, it is also necessary to reduce
Govt. expenditure and work in tandem with monetary policy to contain inflation. In reducing
government expenditure, it is also desirable to link income policies of the Govt., in particular, wage
increases to productivity gains. Attempts are made to minimize income expenditure gaps and avoid
deficit financing from inflationary sources such as bank financing, in particular, borrowing from CBSL.
Govt.'s medium term strategy rests largely on public investments in key sectors and infrastructure that
supports growth. It is important that these investments are financed in such way that it would not place
excess burden on the budget. In this regard, it is encouraging to note that the Govt. has committed to
commence operations of infrastructure projects such as the South Harbour Development, Weerawila
Airport and other highways within the framework of public private partnership, which will provide an
opportunity to the private sector to take part in such projects.
Reducing vulnerability to rising import prices
In view of the significant volatility in oil prices in international markets, CPC has taken measures to
hedge oil imports so that the price fluctuations do not adversely affect domestic prices. It may be worth
exploring the possibility of introducing hedging to other critical imports such as gas, fertilizer to mitigate
impacts of adverse price fluctuations in the domestic market.
3. Banks and financial institutions
Banks and financial institutions are expected to provide finances for economic activity. Some banks
and financial institutions provide credit to government as well as the private sector, while others serve
only the private sector. The continuing high growth in private sector credit could cause a threat to price
stability as well as the financial system stability. High credit growth could deteriorate the quality of
assets of commercial banks and increase the level of non-performing loans. In inflationary situations,
lenders should be cautious not to fuel inflation further, but to direct investment towards productive
activities.
Banks and financial institutions continue to enjoy short term profits from lending at high rates to their
customers and living on interest income. But the real value of their assets and profits continue to erode
in an inflationary environment. For example, the real growth of assets in the banking system in 2006,
was 5% as compared to a nominal growth of 19%. Similarly, the real growth of profits of the banking
sector in 2006 was 12% compared to a nominal growth of 26%. In essence, the real value of short
term profits recorded by the banking sector is only half of the nominal growth. Eventually, there will be
pressures for higher wages which will, together with rising non-performing loans, erode profits and
threaten the stability of the banking system. Banks and financial institutions should therefore take a
longer term view and be more cautious in expanding their loan portfolios towards consumption
oriented credit and promoting consumerism.
The Impact of expansion of consumption credit
Expanding credit to less productive areas specially consumption, would reduce current as well as
potential savings and add to inflationary pressures in a situation where there is limited availability of
goods and services and resources. Such lending would also lead to high credit risks as short term
consumption credit is not backed by realizable collaterals although banks make high profits on interest
income. Banks and financial institutions re-arrange their credit portfolios in a manner that support the
growth and investment drive.
Arranging funding sources without relying on CBSL funds
CBSL wishes to see market liquidity "broadly in balance" as it will enable the Bank to conduct its
monetary policy more effectively. That means when there is excess liquidity in the system, borrowing
from CBSL would add to enhancement of reserve money which will have multiple effects in expanding
money supply and liquidity in the economy. Banks should make concerted efforts to adjust their
funding sources to meet credit demands by mobilizing deposits and enhancing revenue through
feebased activities. For emergencies, they should establish credit lines within their peers. Mobilization of
deposits does not depend solely on high interest rates, but also on improved customer services and
justifiable fees and charges. Similarly, banks should diversify business operations beyond core
business of lending and that will help to reduce high credit risks.
Improvements in efficiency to reduce intermediation costs
Banks need to improve operational efficiency and reduce interest spreads and margins thereby
reducing transaction costs to customers. High spreads and margins and related profits of banks and
financial institutions will raise transaction costs to borrowers and investors who will pass such costs to
customers through high prices of goods and services. This is inflationary. Compared to most countries
in the region, banking and financial services in Sri Lanka are provided at very high margins. For
example, India's interest margin is 2.6% and Bangladesh is 2.5%. In Sri Lanka, it is 4%. In fact, even
the big investors have begun to feel the impact of high transaction costs although many of them have
the bargaining power to obtain funds at prime rates. The medium to small enterprises have no choice
or access to finance.
4. Fund managers/dealers/traders
Interbank market
The tight monetary policy stance adopted by CBSL and its possible continuation would result in
increased reliance by banks on the inter-bank call market. Given the self imposed limits by banks on
lending to each other, if a few banks attempt to raise a large volume of funds from the inter-bank
market , there could be volatility in interest rates. Banks should not often rely on a potentially volatile
call money market as an alternative to mobilizing deposits or exploring other funding sources. The
heavy reliance by some banks on the call money market drives short term interest rates and make
borrowing costs to investors and business community to very high levels. The volatility in the call
market also creates uncertainty among the businesses and that adds to inflationary expectations.
Forex market
Given the current account imbalances, there is a mismatch in foreign exchange inflows and outflows.
Sri Lanka's foreign exchange market is not deep enough to absorb relatively large transactions,
though its size and operations have gradually increased. In such a market, huge speculative trades
could be rather disturbing and they could move the exchange rate against economic fundamentals. No
doubt, forex market is a key source of foreign exchange income to banks. Its price, which is the
exchange rate, is determined according to demand and supply forces. CBSL recognizes that demand
and supply forces should be allowed to determine the exchange rate and that some amount of
speculative trading is needed to develop the market. When there are trade bills of customers or banks
themselves and, if banks do not have adequate forex with them, it is natural to borrow from the
market. However, more often than not, traders/dealers speculate to make short-term gains in the forex
market and try to drive the exchange rate to levels which they prefer it to be. Banks should earn profits
and be financially viable. CBSL wishes to see a well-capitalized and profitable banking sector. In many
instances, it was noted that the exchange rate depreciates to levels which are not in line with inflation
differentials of our trading partners measured through the real effective exchange rate. This could be
due to market domination by a few dealers who wish to earn unusually high profits.
Needless to say that exchange rate depreciation on a continuous basis makes imports more
expensive given the high import content of Sri Lanka's trade basket. High import expenditure has
cascading effects on all imports, including oil and other intermediary goods imports. Then the cost is
felt by entrepreneurs, industries, investors, and finally by the whole country. Banks operating in the
forex market therefore, should not only be concerned of their profits but also of their public policy
responsibilities. In their own interest too, banks should be mindful of the uncertainties they create in
the forex market which is not conducive to its smooth operations and, therefore, the perception by
international markets and investors.
As you are aware, worker remittance has financed around 69% of Sri Lanka's trade deficit. There has
been an increase in worker remittances in the recent past responding to active promotional campaign
launched by CBSL with the support of the Sri Lanka Foreign Employment Bureau, overseas job
agencies, foreign missions and the banks. Recently, the number of professionals and skilled worker
categories were encouraged to take up foreign employment, which is catching up fast. Banks should
make extra efforts to mobilize their remittances, as this will add to their fee-based income through
enhanced financial services. The increase in remittances will have a beneficial impact in reducing the
current account deficit and creating a greater stability in the foreign exchange market.
Govt. securities market
Commercial banks and a few non-banks are the primary dealers who buy and sell Govt. securities and
create secondary transactions in this market. The Govt., tends to borrow from the debt securities
market which is non inflationary. It appears that there are market collusion and cartel type operations
which tend to drive returns on treasury bills and bonds to levels which are not in line with the current
and expected movements in key macro variables. Often, CBSL has to reject bids because of the very
high bidding rates quoted by primary dealers. CBSL is the banker to the Govt. When market collusion
does not enable the Govt., to borrow at reasonable rates, CBSL has to take treasury bills which
inflating financing, as it compels CBSL to issue reserve money into the system which has multiple
effects in increasing money supply and liquidity in the system. Primary dealers, specially the banks,
have a responsible role to play in this regard and be mindful of unusually high bidding and its
repercussions on the whole economy.
5. Investors and the business sector
One way of beating inflation is to enhance productivity. Improvements to the factor productivity should
be introduced using improved technology and higher productivity methods. Investing in technology
today will not only increase productivity but also help lowering product prices. They may have to look
for foreign collaboration, joint ventures and partnerships if additional funding and technical skills are
not available within the country. They should also facilitate investments outside the Western province
and promote regional development and employment generation in outstations while using factors of
production available in such areas.
Businesses and investors have many opportunities under the Public Private Partnership (PPP)
program. Given the Govt.'s commitment to commence large infrastructure projects during this year
and some in 2008, the private investors and businesses could contribute to the development process,
in particular, by participating in infrastructure projects through PPPs. It will help reduce financing of
capital expenditure by the Govt.
Businesses should continue to focus attention on improving, branding, investing in research and
development, and promote innovation. Businesses should increase efficiency of resource usage by
reducing waste. Waste add to cost of production of goods and services. For instance, post harvest
losses in perishable agricultural products is estimated to be around 30%-40% which has been
repeatedly articulated by CBSL in its past annual reports. Businesses should also attempt to shift from
the traditional methods of employing labour and capital towards IT-based new technologies. In
addition, knowledge based product markets should be developed to attract business and knowledge
processing centres. Such activities would not only bring in additional sources of foreign exchange, but
will also move production processes towards high tech methods.
6. Households and the general public
Misconceptions about the term inflation
Inflation is interpreted in various ways by various circles. The price tags on products and services in
shops, supermarkets and service centres is not the inflation but it is the rate of increase in prices. In
other words, it refers to a continuous growth in general price levels in the economy. Households and
the general public should also recognize that short term shocks like droughts, floods and landslides
could temporary raise the prices of basic food items but it will stabilize when situation is back to
normal. The high prices at a given point in time should not be construed as inflation and they need not
build-up inflationary expectations.
Reducing inflationary expectations
The self-fulfilling prophecy that inflation is continuing to rise will eventually result in high inflation. All
stakeholders are informed that action has been taken to reduce inflation by relevant authorities and
that there is hope of bringing it down.
In essence, inflation is eroding the value of assets, wealth and profits of the financial institutions,
businesses, investors and public at large. Inflation can only be beaten with adequate commitment by
all stakeholders.