Road Map: Monetary and Financial Sector Policies for 2020 and Beyond
Excerpts of the speech delivered by Prof. W.D.Lakshman, Governor, Central Bank of Sri Lanka yesterday on the occasion of the launch of Road Map 2020.
The Sri Lankan economy faced significant challenges in 2019, emanating from movements in the global economy as well as domestic developments. Within a single year, across the globe, monetary policies have reversed from tightening to easing, as economies experienced a synchronised slowdown, caused by prevailing conditions in global trade cycle, rising trade barriers, geopolitical uncertainties and numerous structural challenges.
Fiscal and monetary measures put in place in the past to stabilise balance of payments and fiscal balances, and adverse consequences of the Easter Sunday terrorist attacks, combined with the then prevailing political uncertainties have substantially weighed down on the performance of the Sri Lankan economy. The spillover effects of the Easter Sunday attacks in particular, were felt across almost all spheres of economic activity, especially in the second quarter of the year. Consequently, below potential economic growth performance continued through 2019. The economy grew at a slow pace of 2.6 per cent in real terms in the first nine months of 2019.
Growth
The rate of growth for the whole year is likely to be around 2.8 per cent. Even in the years immediately preceding 2019, economic growth was sluggish, with the country failing to maintain the high growth momentum observed in the immediate aftermath of the end of the internal conflict. Policy uncertainty led to weak investor confidence and low levels of investment. Recurring natural disasters worsened conditions. The inability to address structural issues leading to a weak production economy has caused this persistent slowdown. We hope, together with fiscal and other authorities, to formulate policies that will support a sustained revival of real economic activity through improved utilisation of domestic resources, both physical and human. This would help achieving the goal of the government to create productive employment opportunities in the economy on a large scale.
Sustained improvement of living standards of the masses would indeed depend on such employment creation, rather than through a continuation of the transfers-based poverty alleviation measures that the country has become accustomed to over the past several decades. Sri Lanka has been able to achieve commendably high human development results, thanks to past welfare policies, particularly in the spheres of education and health. It is now time to use the extensive human resource base built up over the years and new investments backed up by conducive medium to long term policies, to enhance production growth and expansion of productive employment opportunities. Such employment enhancing growth would be the most effective mechanism to eradicate poverty as well as to achieve balanced regional development.
Inflation
On the inflation front, the country has experienced single digit levels of inflation for the past eleven years. This is an achievement we in the Central Bank are rightly proud of, given its mandated role to ensure economic and price stability in the country. Sri Lanka appears to have broken off from its post-1977 history of highly volatile, often double digit levels of inflation. Behind these inflation achievements however, lies conditions of subdued aggregate demand. This implies a negative output gap that needs to be filled urgently by utilising the available policy space. The monetary policy framework of the Central Bank, in the recent past, has been one of flexible inflation targeting. This is a subject of ongoing intellectual debate around the world. The Central Bank will continue to improve its policy framework in this area, with due emphasis on monetary stability for real sector growth. The maintenance of mid single digit levels of inflation is an essential component of macroeconomic stability; it will protect vulnerable sections of the population; equally, perhaps more, important at times of low inflation, is shared, employment-creating production growth.
The Central Bank has taken a tight monetary policy stance until 2018 in view of high rates of credit and monetary expansion and adverse balance of payments pressures at the time. It now maintains an accommodative monetary policy stance in view of subdued economic growth, muted inflationary pressures and rapidly decelerating private sector credit amidst high nominal and real market interest rates. The Central Bank reduced the Statutory Reserve Ratio (SRR) applicable to all rupee deposit liabilities of commercial banks by a total of 2.50 percentage points in November 2018 and in March 2019. The objective was to provide adequate levels of liquidity to the domestic money market. Helped also by global developments, the Central Bank reduced policy interest rates by a total of 100 basis points in two steps, first in May and then in August 2019.
In spite of monetary policy easing, market interest rates remained high in both nominal and real terms. Private sector credit growth decelerated sharply, particularly during the first half of 2019. This prompted the Central Bank to take regulatory actions of imposing caps on deposit interest rates of financial institutions. This was done in April 2019, with a view to addressing the issue of weak transmission of monetary policy measures. With deposit interest rates and cost of funds declining, the Central Bank removed the caps on deposit interest rates of licensed banks and imposed caps on lending rates, in September 2019. The intention was to induce a sizable reduction in lending rates, thereby increasing credit flows to support the revival of economic growth. As a result, most market interest rates declined, notably during the second half of 2019. The Central Bank expects to review the caps on lending rates, once the financial institutions meet the stipulated reduction in lending rates and credit flows normalise during the year.
In an environment of monetary and fiscal stimulus, measures are to be implemented in the near future to enhance credit flows to small and medium scale enterprises (SMEs). These measures are expected to accelerate credit growth to the private sector in 2020 and beyond, and enable a speedy revival of economic activity. A relief package for reviving SMEs is being designed, particularly targeting non performing advances. For those who seek relief under this package, suspension of legal action and rescheduling of loans along with some interest rate concession have been proposed. The revival of businesses of such borrowers is expected to be facilitated through a grace period for capital repayments and a short term working capital loan. For borrowers in the performing category, a new facility with extended repayment periods including a grace period for capital repayments under reasonable interest rates is being considered.
Banking Sector
In this context, I urge Sri Lanka’s banking sector to rethink its credit disbursement policies, as the traditional ‘risk averse’ mindset has deprived emerging entrepreneurs and new ventures of much needed initial capital. Credit schemes that take into consideration the specific challenges faced by startups have failed to develop. The absence of dedicated development finance institutions is felt strongly, particularly at a time when the SMEs require support from the banking sector for survival during the phase of economic downturn as well as during the period of their takeoff.
The external sector recovered to some extent in 2019 from the significant pressures experienced in 2018. Trade deficit contracted as imports declined rapidly, in response to measures undertaken in mid 2018 to curb non-essential imports, including personal motor vehicles and gold. This greatly contributed to offset the negative impact of the Easter Sunday attacks on tourism and the moderation of workers’ remittances. Consequently, the current account deficit contracted notably. As far as financial flows are concerned, Sri Lanka continued to experience low levels of foreign direct investment (FDI). Outflows from the market for rupee denominated government securities and the stock market continued, albeit at a much slower pace than in the previous year. Given the persistent current account deficit and the inadequacy of non-debt-creating financial flows, the country was compelled to continue relying on debt related inflows to the government. Sri Lanka successfully issued International Sovereign Bonds (ISBs) amounting to US dollars 4.4 billion during 2019. The rupee has shown greater stability in foreign exchange markets, after its significant depreciation in 2018. A marginal appreciation indeed was observed in 2019 for the first time since 2010. Conducive conditions in the domestic foreign exchange markets also paved way for the Central Bank to purchase foreign exchange to build its reserves during the year. Going forward, the production economy will be strengthened, helped by availability of required infrastructure facilities, the prevalence of conducive policy measures, attraction of export oriented FDIs, and the maintenance of appropriate fiscal and monetary conditions. The maintenance of competitive exchange rate will also help. These will lead to a sustained improvement in the country’s balance of payments position as well.
During the year 2019, Sri Lanka went through the fifth and sixth reviews of the Extended Fund Facility (EFF) of the International Monetary Fund (IMF) successfully and received the sixth and seventh tranches of disbursements. We hope to engage with the IMF and other international agencies remaining within the overall national policy framework, negotiating for changes in the IMF programme where changes are considered required.
The year 2019 also witnessed a deviation of the fiscal outcome from the envisaged targets owing to the weak performance in government revenue collection in the context of stagnant economic activity. Although lower than envisaged, a surplus is expected however in the primary balance in 2019. Recent tax reform initiatives constitute a much needed transformation of the country’s tax system towards greater simplicity. The already announced tax relief measures are expected to stimulate the economy while actively contributing to improve business confidence. Any revenue shortfall due to the changes in taxes announced recently is expected to be largely offset by action taken to eliminate unproductive current expenditures and to prioritise capital expenditures. It is expected that the fiscal consolidation path remains intact and the level of public debt stock remains sustainable.
Several policy measures were implemented in 2019 to ensure the continued stability of the financial system and to enhance its strength and resilience to global and domestic shocks. On 01 January 2019, the banking sector successfully completed the Basel III capital phase-in arrangement, to increase the minimum Capital Adequacy Ratio on a staggered basis. Decisive action was taken to address lingering issues with some non bank financial institutions. The spillover of vulnerabilities in those institutions to other parts of the financial system has been prevented.
Across the financial sector, financial institutions were encouraged to improve their own risk management systems and relevant analytical tools. The Central Bank has also undertaken several upgrades to the analytical and monitoring methods for micro and macro prudential regulations to ensure that they are on par with global standard practices. These include the adoption of an internal rating system and an early warning system to identify high risk financial institutions with a view to taking preemptive measures when necessary. Much progress has been made on sustainable finance initiatives as well. In view of Sri Lanka’s increased vulnerability to climate change as well as the availability of environment conscious financial opportunities, these initiatives are gaining traction, and the formulation and launch of the ‘Roadmap for Sustainable Finance’ in April 2019 was a key milestone.
Efficient Methods of Payment
During 2019, the Central Bank continued to take measures to strengthen the payment and settlement infrastructure through modern technology. Financial institutions and the Central Bank have already invested significantly to enhance the usage of innovative systems of digital payment and settlement. It is expected that the general public will increasingly make use of these more efficient methods of payment. Technological advancement and improved people’s awareness in this sphere are the key to bridging the gaps in financial inclusion.
Despite the growing appetite for electronic payments, the use of currency has remained, and will remain, a key feature of the economy. Accordingly, the Central Bank took measures to improve efficiency of currency management and currency operations. With the support of financial institutions and the general public, we have been successful in preserving the quality of currency notes in circulation through the clean note policy.
Public debt management was effectively carried out, ensuring that the government’s financing requirements were met at the lowest possible cost subject to a prudent degree of risk. Debt sustainability conditions were maintained. Together with the Ministry of Finance, the Central Bank took proactive measures to successfully meet the government’s debt service payment commitments in a timely manner during 2019, despite unfounded adverse speculations and criticisms. Having identified the issues and concerns on the implementation of certain provisions of the Foreign Exchange Act No. 12 of 2017 (FEA), the Central Bank revisited the current foreign exchange Regulations, Orders and Directions issued under the provisions of the FEA to further facilitate transactions in the domestic foreign exchange market, while enhancing clarity.
Being the custodian of the Employees’ Provident Fund (EPF), the largest superannuation fund in Sri Lanka, the Central Bank continued to effectively carry out its fund management activities. During 2019, secondary market transactions in government securities and investment activities in the equity market were recommenced, adhering to investment policy statement and approved investment guidelines.
The Central Bank continued its development finance and regional development activities along with concessionary credit operations during 2019 with the aim of achieving inclusive and balanced economic growth and promoting financial inclusiveness in the country. Progress was also made in formulating the National Financial Inclusion Strategy (NFIS) with technical and financial assistance from the International Finance Corporation (IFC). As an outcome of the collective efforts made by the Financial Intelligence Unit (FIU) of Sri Lanka and other stakeholders, in October 2019, Sri Lanka was delisted from the ‘the Grey List’ of the Financial Action Task Force (FATF). FIU continued to comply with the FATF recommendations and expanded intelligence sharing with several foreign counterparts and domestic agencies.
Challenging Global and Domestic Environment
In a challenging global and domestic environment, the Central Bank has achieved a great deal in meeting its objectives of maintaining economic and price stability and financial system stability, with a view to encouraging and promoting the development of the productive resources of Sri Lanka. Going forward, in line with the philosophy of the new government, the Central Bank will continue to improve its contribution for the economy to progress as an upper middle income economy through equitable and inclusive growth of real economic activity of the country.
The developments in the past few years have shown that, at times, there was a tradeoff between macroeconomic stability and economic growth. While stability is important, a people-centric government cannot ignore its social and human development objectives, especially when Sri Lanka is ready for its economic takeoff. We intend to pursue our efforts to find solutions to balance these conflicting objectives of public policy, without compromising economic and price stability and financial system stability.
In this context, this Road Map expects to enunciate the broad policy framework that the Central Bank intends to pursue in the medium term, enabling all stakeholders of the economy to adjust their own future policy plans.
Accordingly, the Road Map 2020 is outlined under the following headings:
Section 2: The Central Bank’s monetary policy strategy and policies for 2020 and beyond
Section 3: The Central Bank’s policies related to the financial sector performance and stability in 2020 and beyond
Section 4: Policies Related to Ancillary and Agency Functions
2. Monetary Policy Strategy and Policies for 2020 and Beyond
Amidst varied challenges on both domestic and global fronts, the Central Bank continued to conduct monetary policy in an increasingly forward looking manner using an evidence based approach with a view to maintaining inflation at low and stable levels over the medium term and anchoring inflation expectations at such levels. These are necessary conditions for the economy to revert to a sustainable high growth path.
Several advanced economies eased monetary policy in consideration of numerous headwinds including increased geopolitical and trade tensions, widespread slowdown in the global economy as well as muted inflation and inflation outlook, led by policy rate cuts by the US Federal Reserve in 2019. A majority of the emerging market and developing economy central banks also adjusted their monetary policy stances to become more accommodative during the year.
The Central Bank of Sri Lanka too moved to an accommodative monetary policy stance in 2019, from the neutral stance that was maintained during most of the previous year. Forward guidance was provided to the market in April 2019 on the possibility of a future reduction in policy interest rates. Subsequently, key policy interest rates, namely the Standing Deposit Facility rate (SDFR) and the Standing Lending Facility Rate (SLFR), were reduced by 50 basis points in May 2019, followed by a further reduction by 50 basis points in August 2019.
Meanwhile, the Central Bank deployed the Statutory Reserve Ratio (SRR) to address large and persistent deficit levels in the domestic money market observed since mid September 2018. Accordingly, the SRR applicable on rupee deposit liabilities of commercial banks was reduced by a total of 2.50 percentage points in November 2018 and March 2019. This released a substantial amount of liquidity into the domestic money market, helping to maintain a surplus level of liquidity since mid April 2019.
In addition to the monetary policy measures taken, several regulatory measures were also introduced. The objective here was to enhance the efficiency of transmission of recent monetary policy measures to influence market lending rates. Caps on deposit rates were imposed in April 2019. As market deposit rates adjusted downwards, deposit caps on licensed banks were removed in September, and instead, caps on lending rates were introduced. There has been a notable downward adjustment in market lending rates as a result of these measures. Market lending rates are expected to decline further in 2020, and the Central Bank will review the caps on lending rates in March 2020 as announced already.
These measures helped revive credit flows to the private sector. Yet credit growth in 2019 was low compared to envisaged levels. Going forward, the Central Bank expects a boost in the growth of credit and money supply with the envisaged further reduction in lending rates and the anticipated improvement in investor sentiments.
Growth of credit to the private sector is expected to pick up to around 12-13 per cent by end 2020. This is sufficient to support a revival of economic activity. Driven by the expected growth in private sector credit, growth of broad money supply is likely to reach around 14 per cent by end 2020. This is not expected to cause any excessive build up of demand pressures with adverse impacts on inflation.
We expect to pursue our resolve to maintain inflation within a range of 4-6 per cent through a transparent, coherent, and accountable monetary policy framework going forward. Maintaining inflation at stable levels would help improve economic prosperity of Sri Lanka. In this regard, the Central Bank will continue its dialogue with fiscal authorities. Adjustments to the Monetary Law Act to align it with global best practices are also envisaged. Improving Central Bank governance, enhancing its independence, transparency and accountability, as well as enhancing fiscal-monetary coordination to achieve price stability, are all extremely desirable features. At the same time, financial sector oversight and macroprudential policies are to be strengthened to ensure financial system stability.
Forecasting and Policy Analysis System
Improvements have been made to the internal institutional arrangements with respect to monetary policy formulation, as well as to further improve the technical and institutional capacity of the Central Bank. Over the past few years, the Central Bank has become increasingly forward looking, supported by macroeconomic projections produced under a full fledged, model based Forecasting and Policy Analysis System (FPAS). Strengthening the technical and institutional capacity of the Central Bank will continue to remain a priority, while staff will be encouraged to explore alternative approaches to designing policies to suit Sri Lanka’s persistent development challenges. The scope and coverage of forward looking indicators and surveys will be further expanded. Among these initiatives is the planned extension of the coverage of the Inflation Expectations Survey (IES) beyond Colombo to the national level. This would provide better information for policy formulation.
However, short term volatility in inflation driven by food prices and global commodity price movements show that long term price stability is also a function of improved real economy as well as appropriate monetary policies.
The current low inflation environment has allowed some space for fiscal as well as monetary stimulus to boost dampened economic activity. In the coming years, as the country progresses towards a higher growth trajectory, close monetary-fiscal coordination is essential to sustain price stability – the conducive platform for further growth. In this context, the Central Bank will work closely with fiscal and other government authorities to ensure a sustained improvement in the production economy and generate productive employment opportunities.
