“Reservoirs are full, oil prices are down”
View(s):On Wednesday, the Governor of the Central Bank Dr. Indrajit Coomaraswamy presented the Central Bank’s “Road Map 2019 – monetary and financial sector policies for 2019 and beyond”. It provides an outline of the Central Bank’s policy directions for the year guiding us to figure out where we intend to move in an uncertain and volatile economic environment, both locally and globally.
While the Central Bank has little to do with what is happening around it, it is responsible for managing the outcome of what has happened. When the outcome of what has happened is “messy”, then the task of the Central Bank becomes challenging.
Perhaps, there is little dispute over the fact that the Central Bank’s task has been much more challenging last year than ever before. The Road Map for 2019 is clear about the fact that its aim is to get the “best possible” combination of its targets – the so-called macroeconomic fundamentals, which do not portray a rosy picture, when looked at them from different angles.
Given the objective of central banking as “managing price stability”, its policies are directed at three basic variables – inflation, exchange rate and interest rates. I am focusing on the challenging task of the Central Bank in managing these macroeconomic fundamentals in the light of the Road Map 2019.
Monetary policy approach
The Central Bank’s monetary policy approach to achieve its prime objective is known as reaching “flexible inflation targeting” which has flexible room for moderate variation when interest rate and exchange rate as well as other factors of the real economy are taken into account. Thus the target range is set as maintaining 4 – 6 per cent annual inflation.
Inflation targeting cannot be an effective approach to monetary policy unless and until the government, or precisely the Treasury collaborates. This is because the government through its budgetary mismanagement can contradict the “inflation targeting” by putting the Central Bank in a difficult position.
The Central Bank adopted tight monetary policy stance since 2015 until mid-2018 to avoid any inflationary pressure building up in the economy. There was a justifiable good reason for the tightened monetary policy as, Sri Lanka and all its economic units including the government have been spending more than what they could afford to. This was well reflected in the country’s “twin deficit”.
Twin deficit
Sri Lanka has evolved as a “twin-deficit” country which has ultimately put the people’s lives in trouble and, central banking on the spot. Twin deficit consists of budget deficit and trade deficit.
Government’s tax revenue has declined over the years from over 20 per cent of GDP to less than 12 per cent, which has been raised now close to 14 per cent. However state expenditure remained over 20 per cent, while the “quality” of various types of government spending has been an issue of concern.
The government kept borrowing in order to finance annual budget deficits, which puts pressure on inflation and interest rates and add to rising public debt. Managing all three – inflation, interest rates and, public debt are under the purview of the Central Bank.
External shock
The other side of the twin deficit is the trade deficit. Sri Lanka’s merchandise exports have fallen over the years from over 33 per cent of GDP to 13 per cent limiting our foreign exchange earning capacity. But import expenditure has been rising faster than exports, causing a widening trade deficit.
Three sources of imports have caused increased imports expenditure in the recent past; gold, vehicles, and oil. The first two have been corrected with policy measures, while oil prices declined now easing the import expenditure.
As a result of the trade deficit, the exchange rate was already under pressure, when it was under attack by external shock – increased interest rates in the US. As a result of the external shock, foreign investment in the stock market and government security market flowed out. The rupee has depreciated by 16 per cent during the year.
External value of the rupee, which is the exchange rate, is also a concern of the Central Bank which intervened only when its depreciation automatically corrected its real market value.
FILE PHOTO: File picture of oil tanks seen at the gas field of Siba in Basra, Iraq. Oil prices have been coming down.
Easing tight monetary policy
Having adopted a successful inflation targeting approach, the Central Bank started loosening its tight monetary policy stance in April 2018. This was led by the favourable inflationary outlook of the country which was within its target zone and, more importantly the need for monetary stimulus for the subdued performance in the real economy – growth, exports and investment.
Here was the dilemma: It was also the time that global interest rates were on the upward path due to tightening monetary policy stance of the US, EU and many other countries. But Sri Lanka needed to stimulate the real economy which has been performing well below its potential.
As a result, here we have been knocked down with sudden foreign exchange outflows causing unprecedented depreciation of the rupee exchange rate against the US dollar and other major currencies.
Downgraded credit rating
Sri Lanka now has to borrow, and it is not a question whether borrowing is right or wrong! Borrowing is not necessarily for investing in building up infrastructure, but for paying public debt. Apart from domestic debt, the Central Bank has to manage paying off about US$ 4 billion foreign debt in 2019.
Nevertheless, borrowing has now become more difficult than it was before the “October turmoil” due to downgrading of credit-worthiness of the country. The political turmoil in October caused three credit rating agencies to downgrade the country’s credit-worthiness rather on political chaos than on economic grounds.
Consequently, Sri Lanka is facing not only the higher global interest rates due to tight monetary policies elsewhere, but also additional risk premium due to downgraded credit worthiness of the country. It is not all for 2019.
Policy directions for 2019
The Road Map is clear about continuation of its monetary policy conduct with strong commitment to inflation targeting that has yielded better results over the years. The low inflation regime will provide Central Bank support for higher growth of the economy and better living standards of the people, even though the achievement of both these real economy outcomes do not depend on Central Bank policies alone.
The Road Map is also clear about its desire to leave room for market-based adjustment of the exchange rate. Besides with a meagre amount of foreign exchange reserves at hand and the forthcoming debt obligations for many years ahead, it is almost impossible and undesirable to commit for stabilisation of the depreciating exchange rate.
Without strong export growth, there is no other way to stabilise exchange rate. As a measure of minimising the volatile foreign exchange flows, the decision to reduce foreign investment in government securities from 10 to 5 per cent of outstanding securities will further demand strong export growth which is not yet there to be seen.
Outlook for 2019
With dismal performance in the real economy – particularly, the slower growth and poor export performance, the Road Map on monetary policy is clear in the conduct of its monetary policy stance which, obviously facilitates real economic performance. In other words, the better delivery of growth and export performance is clearly outside the purview of the monetary policy conduct.
Dr. Coomaraswamy concluded his Road Map presentation, however, with a positive note on the real economy: “Reservoirs are full and, oil prices are down so that we have a hope for 2019”.
We have entered the New Year with these two favourable developments that might ease economic challenges, though it is disappointing to discover that the Sri Lankan economy still depends on the fortune of weather patterns and world oil prices. However, I don’t think that we as Sri Lankans or our representative government can claim the credit for either of them. Can we?
(The writer is a Professor of Economics at the University of Colombo. He can be reached at sirimal@econ.cmb.ac.lk)