CB on oil exploration, money printing and higher education

The following is a compilation of stories based on the Central Bank’s(CB’s) annual report for 2007 released last week:

*** Inflation

The present monetary management and monetary policy conduct is based on the monetary targeting (MT) framework, according to the Central Bank’s 2007 Annual Report. Under this framework, price stability is to be achieved by influencing changes in the broad money supply, which is linked to reserve money through the money multiplier. The Annual Report states that over the years, the MT framework has been gradually developed and modified in line with global and domestic developments in monetary policy and macroeconomic management with a view to moving into an inflation targeting (IT) regime in the future.

IT is described as a monetary policy framework which aims to achieve publicly announced official quantitative inflation targets (target ranges or ceilings) within one or more pre-designated time horizons, using available policy instruments. It is aimed at attaining the price stability objective directly by focusing on deviations in inflation forecasts from an announced inflation target.

The three main characteristics of the IT framework is an inflation target which is designed with a medium to long-term perspective, an inflation forecast and an operating target, usually a short-term interest rate, without any explicit intermediate target to achieve the announced inflation target.

Since 1997, the CB has taken several proactive steps to move towards an IT framework. In 2007, the Annual Report states that the CB began enunciating CB policies through a public policy document (Road Map), which would eventually cover an inflation report as well, under a future IT framework. Further, the CB formally recognized the need for moving towards an IT framework in the medium-term. In 2008, the CB has commenced the process of preparing an inflation index for monetary policy purposes as several inflation targeting countries do not target headline inflation but the core inflation. The CB stated that moving to an IT framework is a gradual and cautious process and not a simple switching option.

*** Oil Exploration in Mannar Basin

Considering the national importance of oil exploration and consistently rising oil prices in the world market, there is a pressing need for encouraging investments and embarking on oil exploration as early as possible, according to the CB. It further stated that creating a healthy competition along with prudential setting of the business environment would ensure maximum benefits to the country. Long-term planning and maintaining credibility, transparency and accountability in the decision making process would play a vital role in attracting investments. At the same time, the CB stated that actions need to be initiated to explore petroleum resources in other areas of offshore Sri Lanka including the Cauvery Basin which is considered to be a proven area of existence of hydrocarbon.

The Annual Report described the recent efforts of oil exploration which commenced with a 2-D (Two Dimensional) seismic survey carried out by Norwegian oil company, TGS-NOPEC in the Mannar Basin which began in 2001 and concluded in 2005. The seismic survey data subsequently acquired by the government in 2006 and analysis of the data show significant potential of the presence of hydrocarbons (oil/gas) in the area. The CB states that although not studied in detail, it is believed there is high potential of hydrocarbons in the Cauvery Basin and other offshore areas of the country.

The Petroleum Resources Development Committee (PRDC), with assistance from the Petroleum Resources Development Secretariat (PRDS) headed by a Secretary General, has called for internationally competitive bids for exploration licences in respect of 3 of remaining 6 blocks (Block No. 2, 3, and 4) and certain bids have been received already.

*** Balanced Regional Development

Despite the efforts of successive governments in implementing various programmes to uplift the regional economy, the CB stated that the country continues to be plagued with significant regional economic disparities. Whilst the Western Province (WP) accounted for 50.1 percent of Gross Domestic Product (GDP) in 2006, each of the other provinces accounted for less than 10 percent of growth.

With about 70 percent of the population living outside the WP, there is a significant increase in demand for goods and services emanating from the rural areas. The government has embarked on an 'inclusive growth strategy' in order to enhance the allocative efficiency of resources to ensure that the benefits of growth are trickled down to the masses in the villages of Sri Lanka. The government's policy on regional development has been enunciated in the 'Ten Year Horizon Development Framework: 2006 – 2016' (Ten-year Vision). In the Ten-year-Vision, the government has indicated its commitment to improving the socio-economic conditions of the entire island through a mixture of infrastructure development, human capital development and enterprise development while providing a safety-net to the needy segments. It is focusing on Public Private Partnerships (PPPs) where the private sector and the public sector are expected to become the 'combined engine of growth and development'.

According to the CB, the Provincial Councils (PC's) system could also make an effective contribution to balanced regional development. PCs need to assess their strengths and opportunities and set themselves key targets on a macro basis for a specific period. In setting macro targets, the probable rate of increase of GDP of WP can be used as the base. The provincial targets should be set to surpass that of WP, over the years, enabling the provinces to catch up with WP. The CB recognizes it is a tough goal but that only such a strategy would lead to balanced regional development in the country.

*** Conflicts of Public-Private Partnerships in Power Generation

The total electricity generation in Sri Lanka during 2007 amounted to 9,814 GWh of which 3,873 GWh or approximately 40 percent was generated by private sector power producers. The CB explained in its Annual Report that the private sector power producers in Sri Lanka consists of Independent Power Producers (IPPs), first introduced in December 1996, and small-scale hydro power generating establishments. A major share of private sector electricity generation is from IPPs through thermal generation amounting to approximately 90 percent (3,528 GWh) of total private sector electricity generation. The CB stated that IPPs play a major role in the power sector by contributing about 1/3 of total electricity generation.

However, according to the CB, in reviewing the performance of IPPs in Sri Lanka, it is observed that most of the goals have not been fulfilled. Based on the perceived goals of engaging IPPs in a country, the major categories of risks of any private sector participant includes currency, payment, political, management and technology and performance risk. The pricing formula based on which the purchase price of power is determined should reflect the extent of risk taken by IPPs and the purchaser, i.e., Ceylon Electricity Board (CEB). However in Sri Lanka, IPPs pricing formula and terms and conditions in Power Purchase Agreement (PPAs) are not compatible with the extent to which IPPs carry the aforesaid risks.

These disadvantageous contracts and arrangements of IPPs reflect serious faults in existing PPAs which have significantly contributed to the losses of CEB and high electricity prices. While the original contracts would have been entered into between the IPPs and CEB having taken into account the urgency of the specific situation in the country at that time, the CB feels it is now necessary to re-visit the contracts and revise the conditions to provide equal benefits to the supplier and the buyer.

*** Higher Education

The CB stated that the existing higher education system in the country faces serious problems due both to its quantitative and qualitative limitations. Quantitative limitations arise due to the limited capacity in universities. Qualitative limitations are two-fold: viability of the system to produce graduates in fields needed by the economy and failure to ensure quality in the degree programmes to be on par with those offered by reputable international universities.

One of the major problems of the university education in Sri Lanka is the mismatch between the supply and the demand. The country has a supply driven university education system with insignificant relevance to labour market and economic requirements. The university education system also continues to function within a government control regulatory framework. The system is highly centralized. According to the CB, there is an urgent need for introducing a market oriented efficient mechanism to the existing education system. Funding is also one of the major obstacles since the university education solely depends on government funds.

The CB suggests increasing private investments in university education which could produce greater benefits including enhanced access to university education. While it would increase the resource mobilization to the university education, it would also help improve the quality of education with increased competitiveness. Creating a favourable environment for private investment in university education requires developing new legislation, regulations and accreditation policies. The government could seek alternative methods to encourage private investment such as establishing private degree awarding colleges/institutions in selected disciplines with quality maintained at high standards or establishing affiliated university colleges.

*** Sri Lanka's debut International Sovereign Bond Issue

The government issued its debut US dollar denominated international sovereign bonds in the international market in October 2007 to mobilize US$500 million from international investors. The CB states that the main purpose was to finance the government's stake in development partner-funded major infrastructure projects and provide bridging finance to ensure timely and smooth implementation of such projects. Development partners usually finance 70 percent of infrastructure project costs, leaving the government to finance the remaining 30 percent. The CB said that in view of the urgent need to implement several infrastructure projects in a timely manner, minimize cost escalations and support higher economic growth, the bond issue was considered an important source of financing.

During January to October 2007, the government had invested approximately Rs.28 billion on large infrastructure development projects including the Hambantota Sea Port, Puttalam Coal Power and Southern Highway amongst others. According to the CB, such sums had been expended in accordance with the amounts earmarked as per the Budget 2007 and had been temporarily financed through Bank borrowing, Treasury bills and Treasury bonds. Of the Rs.56 billion (US$500 million) bond proceeds, approximately Rs.20 billion was used to settle Bank borrowings, Rs.8 billion was used to retire Treasury bills and Rs.6 billion was used to settle payments due in November 2007 relating to the ongoing infrastructure projects.

The CB states that as a prudential debt management strategy, the government also used the balance sum of approximately Rs.22 billion to reduce the Treasury bill stock, in order to gain the advantage of the interest rate differential while having the option of issuing Treasury bills as and when funds are required for infrastructure projects.

The CB further states that with Sri Lanka's limited access to concessionary foreign financing in the future, international sovereign bonds will be an important debt instrument to mobilize foreign funds in the international markets.

*** Money Printing: Fundamentals and Process

The CB states that the planned injection of money needs to be entirely backed by increases in Net Domestic Assets (NDA) and Net Foreign Assets (NFA). For any increase in NDA above the expected level, there should be a corresponding decline in NFA and vice versa to maintain the planned amount of new money injection in a particular year. According to the CB Balance Sheet, the NDA for December 2007 was Rs.292.9 billion and the NFA for December 2007 was Rs.-28.5 billion. In the recent past, the annual percentage increases in new money had been set at around 15 percent per annum while the actual percentage increases from 2002 to 2007 were 12.3, 11.9, 20.9, 15.8, 21.2 and 10.2 percent respectively.

The reserve money growth rates were largely on par with expected economic growth and inflation, except in 2004 and 2006. For example, the reserve money target for 2007 was set at the stringent growth rate of 11.6 percent or in value terms, an increase of Rs.27.7 billion to Rs.267.6 billion. However, the actual amount of reserve money as at end December 2007 was even below at Rs.264.4 billion, resulting in an increase of only Rs.24.6 billion for the year.

The CB states that effective monetary management policies adopted during 2007 helped to maintain the reserve money growth well within the targeted level enabling the CB to effectively neutralize the effects of excessive reserve money expansion experience in 2006.

*** Sub-Prime Mortgage Market Crisis and its Lessons

Significant losses were the result of the sub-prime mortgage market crisis in the US as the value of the underlying mortgage assets declined. Stock markets in many countries also were affected significantly. Perhaps the most severe effect was that the widespread dispersion of credit risk and the unclear impact on financial institutions caused lenders to reduce lending activity or to demand higher interest rates for credit, thus creating a liquidity and credit crunch. This tightening of liquidity conditions spread to many developed markets and even led to run on a British bank, viz, Northern Rock. This liquidity concerns compelled central banks in major economies to inject liquidity to the market on a large scale to maintain market and financial system stability.

The term 'sub-prime' refers to a low credit-worthiness of the borrower. Borrowers who have problems with credit history or are unable to prove sufficient income to support the monthly payment on the loan for which are applying are called sub-prime borrowers. Sub-prime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history and murky personal financial situations of the borrowers.

Due to several factors, the sub-prime mortgage market saw a rapid expansion in the last few years reaching close to US$2 trillion by 2007. Rising interest rates in the US led to the bursting of the housing bubble and consequential high default rates on sub-prime mortgages. Once housing prices started to drop moderately in 2006 – 2007 in many parts of the US, refinancing became rather difficult. The default of loans and foreclosure activity increased dramatically as interest rates of adjustable rate mortgages (SRM) were re-set higher. The increase in default rates affected not only mortgage lenders that retained credit risk, but also corporate and individual investors holding mortgage-backed securities (MBSs) or collateralized debt obligations (CDOs).

A number of factors have together contributed to the crisis. One is the increasing delinquency rates in sub-prime mortgages. Another is the intense competition among lenders and low quality lending. Other factors include the off-balance-sheet exposureof banks, the rapid development of complex financial products through asset securitization outside the regulated entities, lapses of credit rating agencies and the lack of transparency in the over the counter (OTC) markets.

The crisis has highlighted some of the weaknesses in markets, financial institutions and regulatory framework. The CB states that some of the main lessons to be learnt are the importance of liquidity, the need for stress testing under extreme scenarios, enhancing transparency in markets and institutions, eliminating adverse incentives and recognizing the pro-cyclicality of risk.

*** Challenges of Foodflation

The term 'foodflation' can be simply described as increases in food prices, according to several websites on the Internet. For many developing countries, food accounts for a significant share of total consumer expenditure. According to the New Colombo Consumers' Price Index, food has a weight of 47 percent. The CB states that it is obvious that low-income countries are more vulnerable to the direct first-round contribution of food inflation. Food prices could also increase headline CPI indirectly by raising non food prices – for example, through a wage response to higher food prices – especially in poorer countries in which food accounts for a sizable share of total household expenditure.

A significant fraction of current inflation in Sri Lanka is driven by the one-off adjustments in price level due to the increase in international food prices. The impact of high food prices, according to the CB, has obviously deteriorated the purchasing power of an average person, but its impact on various segments of the population is diverse. On one hand, high inflation reallocates the resources in the economy in favor of the affluent. At the same time, the relative increases in prices of food items raise the income of agricultural sector employees. As a result, the impact of current high prices is mostly felt by the urban poor who are predominantly employed in manufacturing and services sector while rural poor has some positive impact through increased agricultural earnings. In spite of the negative impact of high inflation, it has helped to reduce regional disparities to some extent.

In response to the high food prices, the strategies followed by Sri Lanka are allowing to pass the shock to domestic prices without direct subsidies, plans to increase agricultural production, import tariff reductions and directed subsidies. Therefore, Sri Lanka's current inflation reflects the true impact of the external shock, unlike inflation in many other countries where it is partially suppressed through direct subsidies and price controls.