Financial Times

Monetary policy and price stability
By Sunil Karunanayake
The Monetary Board of Sri Lanka, contrary to widespread speculation at its last review, has decided to maintain the policy interest rates at current levels and control the monetary expansion through open-market operations.
Last year the Central Bank increased the rates four times to curb inflationary pressures. Perhaps its no coincidence that just a few days later the government increased the fuel prices after having gone public that subsidies are restricting economic development.

The Central Bank is hopeful that the economic activities will strengthen further in 2006 following the favourable external economic environment and the impressive growth momentum.

It is commendable that Sri Lanka was able to maintain an average growth rate of 6% in 2005 in the background of increasing oil prices, MFA revision on garment exports, natural disasters, heavy defence budget and a volatile political environment.

Globally policy makers and monetary authorities have worked hard to change double-digit inflation to single digits and the topic of deflation too has been discussed more often in recent times.

However, zero inflation is nobody's dream as that would not be the price stability. A little inflation is now considered a better option that zero factor. It was not long ago that the US Federal Reserve Board warned of the dangers of an "unwelcome substantial fall in inflation".

According to the IMF, countries with long-lived political institutions, governments with a strong executive branch and democracies with majoritarian electoral rules are more likely to succeed in price stabilisation efforts.

Low interest and low inflation are certainly good indicators of a stable economy but the underlying assumptions for these conditions need to be looked at carefully. By March 2006 inflation as measured by the point-to-point change in the Colombo Consumers Price Index (CCPI) had fallen to 6.4% from 8% in December 2005. However, the validity of the two indices – CCPI and the Sri Lanka Consumers Price Index – both need to be examined to ensure that the measures relate to the proper ground situation. Its no exaggeration that today the highest component of household budgets are spent on utilities such as electricity, water, gas, telecommunication and transport. Given the increase in fuel, water, electricity and transport costs are bound to increase adding immense pressure to the majority of the population.

Global oil prices haven't stabilised in any manner and for the past several years even with the de-escalation of the Iraq and Palestine conflicts, prices have continued to rise. China has now become a major consumer in energy and the developing countries that have depended heavily on imported oil for electricity generation will face severe hardships. Instability of the US-Iran relationship is another worry. These developments do not tell us that the real inflation is declining but real incomes are likely to fall.

Sri Lanka is a country with modest inflation but is highly vulnerable to external shocks with a heavy dependence on imports for fuel and capital goods, and disproportionate expenditure on the military due to a prolonged conflict. Fortunately the demand for exports has been growing with both industry and agriculture showing steady growth.

Despite a widening trade deficit, growing private remittances enabled the current account deficit to be at moderate levels, while the balance of payment surplus and the reserves continued to grow. These factors no doubt would've influenced the Monetary Board in keeping the policy rates unchanged.

Low interest regimes also can lead countries towards higher consumption through booming credit-card sales and hire purchase financing which could fuel inflation.

Success of the low-policy rates will depend to a great extent on the penetration of such benefits to micro levels engaged in productive economic activity and not only to a few well managed companies who will anyway have a commanding position with the bankers.

The rural economy is yet not fully on board with the banking culture despite the presence of established banks in the key cities in the provinces.
To the small-scale farmer, migrant-dependent family and the craftsman's credit and savings are big issues and they depend to a good extent on the village moneylenders even though the micro finance concept is now continuing to grow. According to researchers, demand for deposit services among the poor far outstrips the availability of services.

It has also been said the poor are creative in saving and the rural housewives are well known for innovative methods of savings, as well as keeping them intact outside the banking system.

The Philippines has come out with an efficient mobile banking system with connectivity provided by cellular phones to attract small savers particularly in the background of inflowing foreign remittances.

Rural banks continue to dominate in the rural economy, but these institutions being small and localised are neither able to borrow cheap nor have any access to preferential credit lines.

The development of micro finance and rural banking should be an area to be given priority to promote banking among rural masses that constitute the majority of the population.

Comments on this article should be sent to the writer at suvink@eureka.lk

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