Financial Times

Balancing act in the face of negative publicity
In response

The pressure from the increasing food prices has, to some extent, negated the demand management efforts of the tight monetary policy during recent times. Picture shows a market place.

The following statement was sent by the Central Bank in response to an article headlined ‘The Governor's balancing act: A counter view’by Harsha De Silva which appeared in the Financial section on July 20, 2008.

The Central Bank said this response attempts to enlighten readers of the true position with regard to the matters referred to in the said article:

Dr de Silva persistently claims that the main cause of recent Sri Lankan inflation is “the massive public expenditure routinely accommodated by the Central Bank (CB)”. The reality however, is entirely different.
Each year, a certain amount of liquidity needs to be injected into an economy to ensure its smooth operation. In Sri Lanka, such injection takes the form of the CB acquiring foreign or domestic assets.

Over the past two years, it is very obvious that these injections of liquidity have been stringently controlled in order to contain the demand pressures. An excessive public expenditure would lead to inflation if it serves to drive the reserve money limits over and above the pre-determined annual and/or periodic targets. In that context, the ground reality is that the CB has successfully maintained its reserve money limits well within the targets in 2007 and so far in 2008. This clearly indicates that the CB has not accommodated any increase in public expenditure.

For purposes of record, it should be noted that the source of the injections of reserve money in 2007 and so far in 2008, has been the increase in net foreign assets of the CB. Hence, in actual fact, it may be noted that the net credit to the government (NCG) from the CB has not increased. Value-wise, NCG from the CB reduced by Rs. 16 billion in 2007, and, by a further Rs. 11.9 billion during the first 5 months of 2008. Therefore, the current high inflation cannot be due to the CB accommodating excessive public expenditure, because quite simply, such an accommodation has not taken place.

The transmission of monetary policy always impacts on inflation with a time lag, and that the current underlying inflation movement has been driven mainly by the massive surge in petroleum and food prices.

Once again, for purposes of record, it must be stated that the meeting of the tight reserve money targets by the CB has effectively led to a rapid deceleration in broad money and credit growth since mid 2007. Therefore, the impact of the tight monetary policy is now being felt, and it is expected to be reflected in the inflation numbers in the second half of 2008 with the tapering off of the impact of the major pass-through of the oil price increases.

Dealing with the “Origin” of the Problem
Dr. de Silva in his article has suggested that the CB should look carefully at the origin of the problem and adjust monetary policy accordingly. It is obvious that the CB has been already doing so, over the past two years. Once again, for purposes of record, the main contributory factors for inflation and how the CB has so far dealt with such factors is set out below:

-Impact of Excessive Monetary Expansion before 2007 – CB has already taken measures to neutralize such impact by setting the monetary expansion limits for 2007 and 2008, taking into account the previous excesses. Even in the future, the CB will continue to maintain appropriately tight levels of reserve money injections, until inflation moderates to a clear downward trend.

-Oil Price Shock – The present policy of pass-through of oil prices is obviously painful as it inevitably leads to substantial increases in price levels. However, the CB considers this pass-through as being a desired practice, from a long term perspective, as has been acknowledged by many other countries as well. In addition, to deal with the expected second round effect of increased domestic fuel prices, the CB has already taken the necessary steps to further tighten the monetary policy.

-Food Price Shock - Many countries in the world are now facing unprecedented inflation in their respective economies due to the steep increases in international food prices. In Sri Lanka too, the pressure from the increasing food prices has, to some extent, negated the demand management efforts of the tight monetary policy during recent times. However, on a more positive note, the results of the sustained tight monetary policies will probably be reflected in the county’s inflation from the second half of 2008 onwards, as the impact of the food price shock starts diminishing.

-Inflation Expectations - Although, Sri Lanka’s core inflation appears to be responding satisfactorily to the tight monetary policy, the prevailing high headline inflation, fueled by pessimistic views of some parties has resulted in raising the inflation expectations. That in turn, has served to increase inflation further. While these expectations are likely to moderate in the near future, when the currently increasing trend in inflation reverses, the CB has also been issuing public communications regularly about the inflation curtailment measures, in order to set out the actual position so that the often exaggerated and erroneous claims could be refuted.

Inflation Measurement Problem
Until 2007, a highly inaccurate measure of inflation based on 1952 expenditure weights, was used as the indicator for Sri Lanka’s official inflation. Finally, in 2007, after several decades, this weakness has been corrected. Nevertheless, it must be acknowledged that an index can never be perfect, and a person may still claim that there are minor technical deficiencies even in the new index.

But yet, a person need not be an expert to understand that the expenditure weights based on a consumption survey of 2002 is certainly more representative and accurate than one based on a 1950 survey! In fact, the country’s true inflation rate is now known to the public with a greater precision than ever before. The fact that Dr. de Silva makes the claim that the revision of the half-century old price index to be in line with international practice, is not a proper action, is further irrefutable evidence of his bias mentality.

Comparing the Incomparables!
The Governor has cautioned that when inflation figures across countries are compared, one has to be cautious as to how such inflation is measured in the different countries. Measured inflation varies significantly depending on the technicalities of constructing the respective index. The expenditure weights across countries vary widely. There are also substantial differences in target populations, base years, numbers of items tracked, geographical coverage of samples, methods of aggregation, methods of compilation, methods of computation, etc. Accordingly, inflation across countries can be accurately and reasonably compared only by allowing for the fundamental differences that exist.

Shocks of the Past
Dr de Silva also attempts to suggest that Sri Lanka has, in the past, faced oil shocks during 1973-75 and 1979-80, and that the country has faced such shocks with better results during such periods. The actual positions however, have been different. During 1973-75, the inflation in the country was largely suppressed through price controls. Yet, the annual average inflation in 1974 reached double digits for the first time after independence. In 1980, the annual average inflation exceeded 26 per cent, the highest annual average inflation recorded so far. In contrast, in 2007 and 2008, our country has faced the most devastating and unprecedented supply side shocks, covering food, oil, metals and pharmaceuticals, all at the same time. Yet, the annual average inflation is presently just over 21 per cent. Dr de Silva would perhaps do well to reflect on these figures.

Fiscal Stimulus on Growth
Available information reveals that the value addition from government services has grown by 5 per cent in 2006 and by 6 per cent in 2007. Such growth figures are less than the overall growth of 7.7 per cent in 2006 and 6.8 per cent in 2007. This indicates that the contribution to the growth from government services, although substantive, has not been as significant as the growth contribution by the private sector, on a relative basis. Further, the share of government services to GDP recorded 7.7 per cent in 2007. However, Dr de Silva attempts to assert that the country’s recent economic growth of above 6 per cent is due to unproductive increases in government services, and that it has no base. This type of hypothetical and uncorroborative assertions is indeed unfortunate and misleading.

Trend in Investor Confidence
Sri Lanka’s debut sovereign bond issue in 2007 received an overwhelming response from international investors, when the US$ 500 million bond issue received subscriptions of over US$ 1,600 million. This response clearly demonstrated the investor confidence in Sri Lanka, notwithstanding the endeavours of certain politically motivated economists and others to derail this national effort. At present, Sri Lanka’s sovereign bond may be trading at a discounted price in the secondary market.

However, due to the prevailing global financial market conditions, that is true with many other international debt instruments as well. At the same time, it should be noted that the primary issuance of the bond was done at the face value, and not at a discounted value and that both bilateral and multilateral lenders continue to commit funds for projects in Sri Lanka. For instance, during the first five months of 2008, Sri Lanka received financial commitments of over US$ 1,000 million from bilateral and multilateral lenders, and the total of committed but yet un-disbursed funds in the pipeline for implementation of various projects by end May 2008, amounted to around US$ 5.5 billion.

Exchange Rate Policy
On the exchange rate issue, the Governor clearly conveyed the strong message that exporters should not attempt to depend on the depreciation of the Sri Lankan rupee against other global currencies, to achieve competitiveness. Today, currency movements and exchange rates are determined by a multitude of factors ranging from economic to market fundamentals, some of which are beyond the control of a single authority. It is in that context, that the Governor emphasized that exporters should enhance their individual competitiveness through the improvement of productivity and other measures, rather than expecting a weaker local currency to boost their exports.

Under the current exchange rate regime in Sri Lanka, the CB intervenes in the foreign exchange market to smoothen out excessive volatility in the exchange rate and to build up its own external reserves. So far, this year, the Sri Lankan rupee has appreciated slightly against the US dollar, and a few other international currencies, partly due to the weakening of the US dollar in the international markets, and partly due to the substantial foreign currency inflows into Sri Lanka by way of foreign investment in Government securities and higher worker remittances. In that background, the CB has, at necessary times, intervened and absorbed excess liquidity in the foreign exchange market as otherwise the Sri Lankan rupee would have appreciated further thereby leading to a further reduction of the competitiveness of Sri Lankan exports.

Theoretically, the depreciation of the value of the domestic currency to reflect the inflation differential between that country and others, would, on the face of it, help improve its export competitiveness. However, there are many other dimensions to that issue, not least being the danger of the simple “calculation” of the differential, when it is well known that inflation rates across countries are not readily comparable.

The impact of the continuous nominal depreciation of the currency on the country’s external debt stock can also be an enormous burden on a country over the long term, and that too, is a factor that needs to be appreciated a lot more in a macro-economic sense. In fact, as illustrated by the Governor in his presentation, out of the total external debt stock of Sri Lanka as at 31st March 2008, Rs. 620 billion (or 48 per cent) has arisen only as a result of the continuous depreciation of the Sri Lankan Rupee.

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