Road Map:
Monetary and Financial Sector Policies for 2018
and Beyond
Delivered by
Dr. Indrajit Coomaraswamy
Governor
Central Bank of Sri Lanka
3 January 2018
1. Introduction
Your Excellencies, Members of the Monetary Board, Senior Deputy Governor, Deputy
Governors and Officials of the Central Bank, Distinguished Invitees, Ladies and Gentlemen,
First, let me warmly welcome you to the presentation of this year's Road Map.
Continuing our tradition that was initiated in 2007, today we are pleased to present the
eleventh Road Map of the Central Bank of Sri Lanka. It is our belief that sharing our future
policy direction and actions would help you to plan your business trajectory with more
certainty. I hope this Road Map will enhance the transparency and clarity of our policies,
which would help you to achieve your targets more effectively. The successful outcomes in
your businesses would ultimately help us to implement our policies more effectively for the
benefit of both the economy and people of Sri Lanka.
The year 2017 was challenging. We have seen economy-wide effects due to inclement
weather conditions. The drought and floods disturbed agriculture activities and agro based
industrial activities. Spillover effects of these adverse weather conditions impacted the
other sectors of the economy as well. As a result, economic growth is expected to be
subdued and lower than we projected at the beginning of the year. The tight monetary
policy stance of the Central Bank as well as the relatively tight fiscal policy stance of the
government, which were adopted with the aim of regaining macroeconomic stability, partly
affected public and private investment spending that also contributed to low economic
growth. Consumer price inflation increased, mainly due to high food prices associated with
weather related domestic supply disruptions, revisions to indirect taxes and increased prices
of imported commodities, making our efforts to anchor inflation expectations challenging.
Despite the tight monetary policy stance maintained by the Central Bank, growth of
monetary aggregates was high during most of 2017, before decelerating to envisaged levels
towards the end of the year. Although we have seen signs of a firm recovery in exports with
better prospects in key export markets and the flexible exchange rate policy of the Central
Bank, the trade account continued to be affected by a largely weather induced increase in
import expenditure. The decline in workers' remittances resulted in a reduction in the
cushion against the widening trade deficit in the external current account. Although the
fiscal sector has recorded notable improvements in terms of revenue collection, some
slippage in the budget deficit is likely in 2017 mainly as a result of weather related fiscal costs
and higher interest payments. This could have an adverse impact on achieving the envisaged
fiscal consolidation path, while complicating the conduct of monetary and exchange rate
policies.
Despite these challenges, 2017 was a year when we made significant progress on many
fronts through several policy measures taken by the Central Bank in coordination with the
government. In response to these measures, macroeconomic stability is being restored and
our economy is trending in the right direction. The Central Bank has implemented several
proactive policy measures during 2017 in order to achieve the core objectives of maintaining
economic and price stability and financial system stability. Three frameworks have been put
in place to improve the country's overall macroeconomic conditions. Attention is also being
paid to institutionalising them. The Central Bank is working towards implementing a Flexible
Inflation Targeting (FIT) framework by 2020 to conduct monetary policy in a proactive and
forward-looking manner. It has also adopted a more flexible exchange rate policy that
promotes export competitiveness. The government is also committed to a revenue based
fiscal consolidation programme, which intends to bring down budget deficits and debt levels
progressively. If we get fiscal policy and monetary policy right, then the pressure on the
exchange rate would reduce. Let me discuss these frameworks in a detailed manner.
On the monetary policy framework, the Central Bank's move towards introducing a FIT
regime aims to maintain a low inflation environment on a sustained basis. The FIT
framework is a data-driven, forward-looking and proactive monetary policy regime built
upon three main pillars: strong fiscal policy support, effective monetary policy conduct, and
strong central bank mandate and credibility. The government has also endorsed this move
to adopt a FIT regime as stated in its Vision 2025 policy document. In order to successfully
implement the FIT framework, we have formulated a road map outlining several milestones
to be completed by the government and the Central Bank, including the necessary
legislative, institutional and operational changes. The International Monetary Fund (IMF) has
also recognised our move towards FIT by giving us necessary technical assistance on
capacity building.
The Central Bank accommodated greater flexibility in the exchange rate in 2017 by allowing
market forces to determine the rate. The market reacted positively to this policy initiative by
reviving the spot market. The Central Bank continued to absorb foreign exchange from the
domestic interbank foreign exchange market in order to build up the quantum of non-
borrowed foreign exchange reserves. This move also helped to smoothen the exchange rate
behaviour. There were even some instances of appreciation of the rupee in 2017, indicating
significant inflows to the foreign exchange market. Sri Lanka also received the fourth
tranche of the Extended Fund Facility (EFF) of the IMF in December 2017. A total of US
dollars 759.9 million has been received so far. This confirms Sri Lanka's satisfactory
performance in achieving IMF-EFF targets during 2017 in terms of specified performance
criteria and certain structural benchmarks. Earnings from exports increased owing to the
recovery in key export markets, the Central Bank policy of maintaining exchange rate
flexibility, conducive external trade policies and improved macroeconomic conditions of the
country. Further, the reinstatement of the EU GSP+ facility, the expected conclusion of the
free trade agreements with Singapore, China and India and strong institutional and policy
support are also expected to drive the momentum in exports.
We have seen an increased inflow of Foreign Direct Investment (FDI) in 2017 and we expect
FDI to gain momentum through the commencement of the Hambantota industrial zone and
the continuation of the Colombo Port City project. Higher inflows to the government
securities market and the Colombo Stock Exchange (CSE) as well as long term financial flows
to the government were also witnessed during the year. With these developments on the
external front, the Central Bank was able to build official reserves of over US dollars 7.9
billion at the end of 2017.
On the fiscal front, the government has embarked on a revenue based fiscal consolidation
path to strengthen the country's public finances. The government expects to reduce the
budget deficit to 3.5 per cent of GDP by 2020 and thereby reduce government debt to a
sustainable level in the medium-term. It is in the process of implementing several reforms
aimed at improving government revenue collection while rationalising government
expenditures to adhere to the envisaged fiscal consolidation path over the medium-term. A
positive primary balance is expected in 2017 for the first time since the early 1950s and a
surplus in the current account is also expected in 2018 for the first time since 1987. The
reform agenda of the government includes improving financial viability of the State Owned
Enterprises (SOEs) to mitigate the budgetary implications for the government.
While introducing clear frameworks and reforms in relation to monetary and exchange rate
policies in 2017, we have implemented several policy measures during 2017 to address the
challenges in the financial sector and maintain a stable financial system for effective
monetary policy transmission and to support sustainable growth. With a view to promote a
dynamic and resilient financial sector, the regulatory and supervisory framework of the
Central Bank was further strengthened in line with international standards and best
practices. At present, our banking sector accounts for over Rs. 10 trillion in assets, while the
non-bank financial institutions sector accounts for over Rs. 1 trillion in assets. The
implementation of Basel III capital standards was commenced in 2017 in order to develop a
more robust banking sector. The framework to regulate the non-bank financial institutions
was strengthened under challenging conditions, and resolution of distressed finance
companies was also commenced. During 2017, the Central Bank continued to strengthen the
regulatory framework for the microfinance sector, and continued to combat the menace of
illegal pyramid schemes with the assistance of other government agencies. Several
measures were adopted to strengthen and modernise the payment and settlement
infrastructure in order to develop an efficient and stable payment and settlement system in
the country, as well as to pave the way towards a digital economy.
Being a trusted, professionally competent and strong institution, the Central Bank is
entrusted with vital agency functions. Accordingly, as per our mandate, we carried out
public debt management with the objective of mobilising the government's financing
requirements at the lowest possible cost and with a prudent degree of risk. The framework
for public debt management was reinforced by introducing a transparent market based
auction mechanism for the issuance of government securities. This has already resulted in
desirable outcomes of lowering interest costs to the government, efficient price discovery
and improved transmission of monetary policy signals across the benchmark yield curve. The
Employees' Provident Fund, which is the largest superannuation fund in the country, is
managed by the Central Bank. It passed a significant milestone during 2017 with total assets
of the Fund surpassing Rs. 2.0 trillion. The Central Bank also continued to promote financial
literacy and inclusiveness and helped entrepreneurship development through our credit
schemes for agriculture and livestock, as well as the micro, small and medium scale
enterprise (MSME) sectors. In addition, we also adopted measures to promote a clean note
policy in the country and improvements were also made in currency operations and
processing. In 2017, the Central Bank implemented a new legislative and a policy framework
for foreign exchange operations based on the Foreign Exchange Act, No. 12 of 2017.
Provisions of the new Act are being implemented through the newly established
Department of Foreign Exchange in the Central Bank focusing on reducing restrictions,
excluding ambiguities, simplifying processes and enhancing efficiency associated with
foreign exchange transactions while striving for clarity and convenience.
A significant amount of work needs to be done to improve Sri Lanka's global ranking in the
implementation of Anti-Money Laundering and Countering the Financing of Terrorism
(AML/CFT) regulations. The Financial Intelligence Unit of the Central Bank is taking several
measures to address this with the assistance of key government Ministries and Departments
as well as stakeholders such as Licensed Banks, Licensed Finance Companies, Regulators,
Stock Brokers and Insurance Companies, and continued to enter into new MOUs with other
country FIUs.
The Central Bank has already initiated several measures to enhance the economic stability of
the country and it will continue with this endeavor in the future as well. Given improved
economic fundamentals and stability, it is expected that the government will implement the
necessary policy reforms to uplift the economy from the prevailing low growth trajectory to
reach its potential level. The government's Vision 2025 unveils the future policy direction of
the country. The Vision envisages transforming Sri Lanka into a hub of the Indian Ocean,
with a knowledge-based, highly competitive, social-market economy. Accordingly,
considering the limited scope of the domestic market, sustained future economic growth
would have to be generated from external demand. Hence, effective and sustainable long-
term policy measures have to be implemented for accessing foreign markets through
exploiting trade and investment opportunities.
We also observe that frequent natural calamities hamper economic activity resulting in a
moderation of economic expansion. This highlights the need for diversification of growth
drivers in the economy as well as putting the necessary measures in place to strengthen the
economy's resilience through mainstreaming sustainability into the planning and budgeting
processes and improving disaster preparedness.
In the global context, after having a series of economic distortions and negative shocks after
the Global Financial Crisis, now the global economy is gradually recovering. Investment
conditions have improved and global trade also rebounded in 2017. So, we need to exploit
opportunities created by the revival of global growth supported by synchronized economic
expansion in Europe, Japan and the US for the first time since the Global Financial Crisis.
Better prospects in Europe and the US, which are our two largest markets, are clearly
tailwinds. This is growth positive for Sri Lanka. However, we should also be mindful that
gradual normalisation of monetary policies in the advanced countries could pose some
challenges to the economy on both external and fiscal fronts.
Sri Lanka is gradually transforming to upper middle income economy status. Sustained
progress will inevitably involve greater integration with the world economy. While creating
opportunities, this will also expose the economy to greater uncertainties and risks. In order
to face the current and future challenges proactively, and to address the already identified
deficiencies in the existing processes, the Central Bank, as outlined in its latest Strategic Plan
for the medium term, expects to robustly strengthen its institutional frameworks by:
a) enhancing the monetary policy framework; b) strengthening the financial sector
oversight; c) modernising payment and settlements; and, d) upgrading public debt
management.
The improved policy frameworks will enable the country to take advantage of greater
integration, while mitigating the risks involved and increasing the resilience of the economy.
In this respect, as already mentioned, we are steadily progressing towards an effective FIT
framework to ensure price stability. At the same time, we are striving to promote a dynamic
and resilient financial sector in order to lower vulnerabilities in the financial system. This is a
priority for achieving objectives in relation to growth, employment and incomes.
Modernising the infrastructure of the payments and settlements system to pave the path
towards a less cash society and facilitating a digital economy are also important policy
priorities in the medium term. We are also determined to strive for prudent debt
management with a view to ensure debt sustainability, enhance effectiveness and
transparency of the primary auction system, promote market development and minimise
risks. Our policies are aligned to achieve these strategic priorities which will be instrumental
in supporting the country's economic and price stability and financial system stability. In this
context, the Road Map 2018 reviews the policy actions that have been pursued during 2017
and more importantly, proposes policies and actions for the forthcoming period.
Accordingly, the outline of the Road Map 2018 is as follows:
Section 2: The Central Bank's monetary policy strategy and policies for 2018 and
beyond
Section 3: The Central Bank's policies related to the financial sector performance
and stability in 2018 and beyond
Section 4: Key policies related to strengthening the broader economy through
the Central Bank's agency and ancillary functions
Now, let me elaborate on these sections in a detailed manner.
2. Monetary Policy Strategy and Policies for 2018 and Beyond
The Central Bank is entrusted with the task of maintaining price stability. Price stability
remains a key fundamental in fostering an environment conducive for sustained growth and
securing rising living standards for the people.
The Central Bank seeks to achieve its price stability objective through the conduct of
monetary policy. Based on the current monetary policy framework, we have been able to
maintain inflation in single digits for close to a decade.
Going forward, the introduction of an effective Flexible Inflation Targeting (FIT) framework
will improve our capacity to deliver price stability. This will provide a more propitious
environment for growth and employment generation.
Our motivation towards adopting inflation targeting as the monetary policy framework was
signaled a number of years ago, as we recognised it as the most appropriate way to escape
from the high inflation-low growth trap. The weakened relationship between money and
inflation and deepening financial markets were among the major factors that encouraged
this move.
Under the proposed FIT framework, the Central Bank will aim to preserve price stability of
the economy by targeting an inflation range of 4-6 per cent. We believe that this target
range is desirable for a country like ours in view of the vulnerability of the economy to
supply or external shocks. We will employ market-based instruments, particularly the policy
interest rates and open market operations (OMO) of the Central Bank, to influence market
conditions and to navigate inflation in the targeted mid-single digit range. Variables such as
overall monetary expansion and credit disbursements to the private sector by commercial
banks will remain as key indicative variables to guide monetary policy conduct.
We have now progressed into a time-bound plan to make this leap towards FIT a reality. The
period starting from 2018 will be vital in laying out required reforms to facilitate a smooth
transition to a FIT framework.
In this context, we have identified three important pillars as the building blocks for adopting
a FIT framework;
1. Strong Central Bank mandate and credibility
2. Effective monetary policy conduct
3. Strong fiscal policy support and commitment
Now let me discuss some key elements and building blocks of FIT.
A strong Central Bank mandate and credibility is essential for successful adoption of FIT.
There is considerable evidence from around the world that weak legal mandates together
with inadequate autonomy of central banks hinder the success of FIT. In this context, Sri
Lanka will also have to introduce considerable changes to the existing mandate of the
Central Bank through necessary legal reforms. The current framework is hampered by the
focus on non-core activities, monetary financing and inadequate autonomy. These factors
are structural impediments in the transition path towards FIT. Amending the Monetary Law
Act (MLA) is, therefore, imperative to enhance the focus of the mandate as well as Central
Bank autonomy, governance, transparency and accountability. These amendments would
broadly include strengthening the mandate of price stability, separating the monetary and
fiscal functions, strengthening the Central Bank's autonomy, and introducing institutional
arrangements for setting inflation targets and maintaining accountability.
Second, to assure effective monetary policy conduct as a vital building block for maintaining
low inflation under the FIT, we need to establish a sound, forward-looking decision-making
process, based on reliable macroeconomic forecasts and projections. In this connection, the
Central Bank has already improved technical capacity in modelling and forecasting of key
macroeconomic variables. The Central Bank and the IMF have jointly developed a structural
model-based Forecasting and Policy Analysis System (FPAS), which encompasses near-term and
medium-term model-based projections. The current policy formulation process is gradually
being aligned with the analysis based on FPAS. This is supporting the monetary policy
formulation process in a more proactive and forward-looking manner. The Central Bank will
continue to improve model-based projections through building sound technical infrastructure
for inflation forecasting and macroeconomic analyses.
Moreover, the monetary policy formulation process is also being upgraded by introducing a
forecast calendar, which outlines schedules for projections and revisions of forecasts linked
to the availability of important economic data and events. Accordingly, during each
monetary policy round, two technical staff level meetings are conducted to obtain inputs
and feedback for forecasting followed by a pre-Monetary Policy Committee (MPC) meeting
attended by the members of the MPC and technical staff to discuss projections and sectoral
developments. The formal MPC meeting takes place subsequently to make
recommendations to the Monetary Board. The number of MPC meetings during a year were
also reduced to 8, allowing sufficient time for technical staff to undertake more
sophisticated macroeconomic analysis.
In the new forward-looking framework, it is of utmost importance to monitor developments
in both current and future economic conditions. In this regard, we will strengthen the
existing surveys of expectations and economic conditions to gain forward-looking insights
to improve accuracy of forecasts.
With regard to monetary operations, the domestic money market is being actively managed
through OMO to steer the Average Weighted Call Money Rate (AWCMR) in line with the
monetary policy stance of the Central Bank. We have taken several progressive measures to
communicate more information, including cut-off yield rates of the OMO auctions and overnight
liquidity estimates with a view to encouraging more efficient price discovery in the money market
and promoting informed decision making by market participants as well as to improve market
signaling of OMO. The Central Bank will continue to actively engage in liquidity management,
while guiding the short-term interest rates along a desired path. Several measures, such as
reviewing the compilation methodology of benchmark interest rates, strengthening the
operational framework pertaining to the Intraday Liquidity Facility (ILF), introducing a rule-based
code of conduct for Authorised Money Brokers and promoting market development will be taken
to improve the efficiency and compliance in respect of money market operations.
As announced last year, the Monetary Policy Consultation Committee (MPCC) was re-
established in mid-2017 to draw on external expertise to support the conduct of monetary
policy. We will continue to take on board stakeholders' views and align our policies in a way,
which is mutually beneficial for stakeholders and the Central Bank.
As the conduct of monetary policy is dependent on an effective and prudent exchange rate
policy, the Central Bank has introduced a more market based exchange rate system. It has
allowed more flexibility in determining the exchange rate based on the market conditions
and has intervened only to smoothen volatility and to build up reserves. It is noteworthy
that there has been a build-up of non-debt creating international reserves during 2017, with
minimal impact on the exchange rate. Going forward, foreign exchange intervention policies
will be adopted, which are consistent with a flexible exchange rate regime and supportive of
improving foreign exchange market functionality. Maintaining a competitive exchange rate
will be an important objective of the Central Bank.
In line with this policy, we will continue to focus more on non-debt creating financial flows
in building up reserves. Ongoing policy reforms of the government focus on boosting
exports as well as attracting FDI. This gives greater salience to our agenda of maintaining
flexibility in the exchange rate to boost competitiveness. The Board of Investment (BOI) has
estimated FDI to have reached US dollars 1.5 billion in 2017, which will be a key milestone and
could possibly be a turning point in FDI inflows. The commencement of the Hambantota
Industrial Zone and the continuation of the Colombo Port City project are expected to bring
significant FDI flows from 2018 onwards. Annual FDI flows of US dollars 2-3 billion are
expected in the coming years. In addition to boosting growth and employment, it will also
enhance external sector resilience by generating non-debt creating inflows and boosting
exports.
The Central Bank will continue to manage reserves in line with a model based Strategic
Asset Allocation framework (SAA), to ensure foreign exchange reserves are managed with
the objective of ensuring an adequate level of liquidity and a reasonable return in
comparison to benchmarks.
Inflation targeting is well understood as "management of expectations". Monetary policy
affects inflation and the real economy mainly through its effects on private-sector
expectations about future interest rates, inflation and economic activity. In this context,
transparency in monetary policy is vital. This places a very high premium on effective
communication. We believe our communication must be open, objective and up to date in
order to effectively anchor expectations of the stakeholders. Therefore, we are working on
improving the Central Bank's communication strategy in order to enhance public
understanding of the new framework.
Several initiatives are already being pursued to enhance communication. This Road map
remains at the centre of this communication policy. We already set out the macroeconomic
direction of the economy over the medium-term through several year-round publications,
press releases and press conferences. Further, as per the Road Map set out for FIT, several
other initiatives, including further enhancing the analytical value of the Monetary Policy
Review statement, issuing regular Monetary Policy Reports, publishing Inflation Reports and
launching a public awareness outreach programme are also on our menu in the transition
towards FIT.
In accordance with our commitment to set out an advance release calendar for the regular
monetary policy announcements, we would like to announce the following calendar for the
year 2018.
Monetary Policy Announcements in 2018
1 16 February, Friday
2 4 April, Wednesday
3 11 May, Friday
4 29 June, Friday
5 3 August, Friday
6 28 September, Friday
7 14 November, Wednesday
8 28 December, Friday
The Central Bank cannot implement a successful FIT framework alone. As we have
emphasised in the past, the continued and strong commitment of the government will be
of paramount importance.
It is encouraging that the government has already recognised the Central Bank's move
towards FIT as the future framework for monetary policy, in its policy document "Vision
2025- A Country Enriched".
Continued strong commitment of the government towards greater fiscal discipline and
stronger fiscal outcomes remain key to the successful adoption of FIT. In particular, the
government is expected to maintain its commitment to medium-term fiscal consolidation,
which is embedded in the IMF-EFF arrangement. The improved fiscal space through
continued fiscal consolidation will create a better enabling environment for the effective
and independent conduct of monetary policy.
This whole effort requires the government's commitment to remain on the trajectory of
fiscal consolidation it has enunciated in its medium-term budgetary framework. The new
Inland Revenue Act, enacted with the aim of simplifying and rationalising the existing
income tax structure; the VAT reforms; and the improvements in tax administration are
worthy achievements. Further, the government expects to strengthen fiscal consolidation
by revising the Fiscal Management (Responsibility) Act to include binding fiscal targets. This
would institutionalize its commitment to fiscal discipline, which is essential given the
country's external debt dynamics and exposure to rating agencies and international capital
markets.
Further, to institutionalise the autonomy of the Central Bank, it is vital to shield monetary
policy from fiscal dominance. In this regard, a strong legal and institutional mandate for the
Central Bank is expected to ensure a clear separation between monetary and fiscal policy as
part of the transition to the FIT. This requires phasing out of monetisation of fiscal deficits by
the Central Bank. This will also pave the way to a deeper and liquid financial market which
will be a catalyst for effective transmission of monetary policy actions of the Central Bank.
We also see the proposed Liability Management Act of the government as a prudent
strategy. It allows the government to manage public debt in a more flexible manner. Under
this framework, the public debt manager would create a buffer fund to minimise the rollover
risk of debt stock eliminating the necessity for the Central Bank to provide financial
assistance to the government at the beginning of each year as per the current provisions of
the MLA. Even more importantly, it will create the space to go beyond the government's
borrowing requirement in any given year to mobilise financing to address the current
bunching of external debt payments from 2019. The government's decision to earmark the
proceeds of divestitures for liability management is also a very favourable development in
this regard.
Meanwhile, the government's commitment to reform state owned enterprises (SOEs) is
commendable. In particular, automatic pricing mechanisms for fuel and electricity are
expected to be introduced in March and September 2018, respectively. This will go a long
way towards reducing the future financial losses of key SOEs and avoid large ad hoc
adjustments in retail prices. Not only will this be supportive of the effective conduct of
monetary policy, but it will also have a positive impact on the balance sheets of both the
government and the state banks.
As we know, the Central Bank alone cannot manage inflation and inflation expectations in
the economy. It cannot influence supply side factors affecting inflation. Although monetary
policy is effective in controlling demand driven inflation, the support of the government is
essential in managing supply side pressures on inflation. In this regard, timely support of
the government is necessary in dampening supply shocks, thereby anchoring inflation.
Several key milestones need to be reached over the next three years through the joint
efforts and the commitment of the government and the Central Bank to fulfill the key
prerequisites of the FIT framework. Legal amendments, continuation of fiscal consolidation,
institutionalisation of the required changes to the monetary and fiscal policy processes, and
building awareness and the confidence of the general public are the priorities in the near
future before the official transition to the FIT framework by 2020.
In this regard, as mentioned, we have devised a Road Map for adopting FIT, outlining the
necessary reforms and innovations. This is largely aimed at institutional features,
organisational features, operational features, monetary policy implementation, exchange
rate policy and foreign exchange operations as well as capacity building, while aligning both
fiscal and monetary policy towards achieving economic targets set in a coherent manner.
When setting our monetary policy actions and directions, we cannot disregard the external
environment. In the global economy, for the first time since the Global Financial Crisis, there
is currently a divergence of monetary policy among the major economies. This is likely to
result in greater volatility in capital and currency markets. This requires us to be vigilant. We
are aware that interest rate hikes in advance economies such as the US and the UK as well as
in emerging economies could have some spillover impact on the Sri Lankan economy
through capital reallocation. Meanwhile, economic and political developments in major
export destinations, as well as trends in key commodity prices, will also have a significant
impact on the domestic economy.
3. Financial Sector Policies for 2018 and Beyond
Being guided by its mandate, the Central Bank promotes a dynamic and resilient financial
s