IMF urges revamping SL’s Monetary Policy amid economic crisis
Sri Lanka’s monetary policy is grappling with dual crises; the economic downturn and the lingering effects of the pandemic, according to the latest technical report released by the International Monetary Fund (IMF).
The IMF South Asia Regional Training and Technical Assistance Centre (SARTTAC) mission visited Colombo recently and provided technical assistance (TA) on setting-up of liquidity monitoring tools with the objective of improving daily monitoring of Central Bank (CB) liquidity in domestic currency.
Transitioning to a more flexible inflation-targeting approach, a cornerstone of modern monetary policy requires stabilising the macroeconomic environment through structural reforms.
Key steps in this process include eliminating monetary financing (central bank funding of government deficits) and anchoring inflation expectations by maintaining low and stable inflation, the report highlighted. A systematic approach is essential for modernising monetary policy instruments and operations.
This progress, however, hinges on ongoing debt restructuring efforts, managing financial risks, improving the balance sheet of the Central Bank and stabilising the broader economy, it warned.
The modernisation framework is divided into multiple stages, with certain actions being taken immediately and others deferred until the financial system regains stability.
The IMF mission recommended that CB shift from using two policy rates to a single policy rate, enhancing its ability to steer market interest rates and communicate its monetary stance more effectively.
This would also streamline the communication process, making the policy direction clearer. Moreover, the mission advised against imposing restrictions on access to the CB’s standing facilities, even if such measures are meant to be temporary.
Restrictions could disrupt market-based interest rate adjustments and damage the credibility of the central bank.
As part of modernising the interest rate system, CB could consider widening the Interest Rate Corridor (IRC). In addition, the CB should begin scaling back the use of its monetary instruments to support the domestic bond market (specifically, Sri Lankan Rupee or LKR bonds).
The instruments used by the CB for monetary policy should not be available to non-bank primary dealers to finance their LKR bond market operations.
During the second stage of reform, a transitional model for monetary operations is proposed, focusing on weekly liquidity operations on a predetermined schedule.
Since CB cannot yet target aggregate liquidity in the system, it will need to address liquidity demands across different market segments. As financial stability improves, adjustments to the reserve requirement framework will be necessary, such as aligning requirements for local and foreign currency reserves and modifying the reserve maintenance period.
Later stages envision CB managing overall liquidity, with Open Market Operations (OMOs) calibrated based on liquidity forecasts. The goal is to return to a mid-corridor system, where OMOs align with CB’s monetary policy committee announcements.
The CB already monitors liquidity through an operational liquidity forecasting tool, primarily based on daily data from CB units and reports from commercial banks.
However, improvements in forecasting, especially given the unusual banking arrangements with the government’s accounts, are essential. Enhanced forecasting tools, improved data formats, and daily balance sheet updates will ensure more accurate liquidity management.
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