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Monetary policy frame work in Sri Lanka

Monetary Targeting
As Griffiths and Wood (1981) point out, monetary targeting, that is, the
adoption of quantitative targets for the rate of growth of the money supply as
the basis of monetary policy, began in the 1970s in industrialised countries.
Monetary targeting was adopted as a mechanism to bring the chronic high
inflation and fluctuations in output at the time under control, as controlling
interest rates and credit conditions, which had up to then been the practice,
had failed in this regard.
The ultimate objective of the conduct of the monetary policy by the Central
Bank of Sri Lanka is to regulate monetary conditions and price developments.
It has evolved gradually over the past sixty six years. Under the fixed
exchange rate regime that was in place until 1977 as well as during the
period of the managed floating exchange rate regime that existed until the
adoption of a floating exchange rate in 2001, the exchange rate played a key
role in anchoring inflation expectations.
Inflation Targeting
It is characterized by,
An announced numerical inflation target
An inflation forecast, which facilitate forward looking monetary
policy decision making
High degree of transparency and accountability
Inflation targeting central banks exhibit anti-transparency, contrary to the
commonly accepted view that inflation targeting central banks are highly
transparent.
This is most explicit in the inflation targeting framework suggested by
Svensson (1997), he explains that, in the case of an inflation targeting central
bank, while the decision as to how rapidly inflation should be brought back to
the desired rate after some departure from it depends on the strength of the
central banks preferences with respect to inflation vis--vis its other
objectives, it is not common for inflation targeting central banks to be explicit
about the level of output or employment that they regard as desirable or the
weights they attach to such objectives.
In this regard, it is pertinent to point out that Svensson (2005) in fact states
that inflation-targeting central banks can make substantial additional

progress by being more specific, systematic, and transparent about their


operational objectives (in the form of using an explicit inter-temporal loss
function), their forecasts , and their communication (in the form of
announcing optimal projections of the instrument rate and target variables).
(Svensson, 2005)
The adoption of Monetary targeting
The adoption of Monetary targeting (MT) as its monetary policy framework, by
the Central Bank of Sri Lanka was during the early1980's, and monetary
aggregates became the key factor to conduct of monetary policy in Sri Lanka.
For the stable maintenance of price, reserve money was considered as the
operating target of monetary policy under this framework.
For each year, the MT framework required targets for reserve money and
broad money growth to be announced and monitored, based on the annual
monetary programme prepared by the Central Bank considering various
factors, such as the expected fiscal and balance of payments developments,
expected economic growth, desired levels of growth in credit and inflation.
Comparison of Monetary targeting and Inflation targeting
Monetary targeting differs significantly from inflation targeting, although both
frameworks for monetary policy have as the ultimate objective, price stability.
Indeed, within an inflation targeting framework too, monetary aggregates
would be considered important information variables.
Recent Global Developments in Monetary Policy Framework
In Monetary policy conduct under the MT framework, the rapport between
goal variable and the nominal anchor should be consistent and strong for the
effective usage of monetary aggregate targeting and to gain expected results.
In practice, IT is flexible rather than strict, and most of the central banks do
not only aim at stabilising inflation around an inflation target, but also put
efforts
in to stabilising other macroeconomic variables in the economy.
Adoption of Flexible Inflation Targeting (FIT) in Sri Lanka
All IT central banks conduct flexible inflation targeting (FIT) rather than strict
IT.

FIT aims at stabilising both inflation around the inflation target, and the real
economy, whereas strict IT aims at stabilising only inflation, with little regard
to the stability of the real economy. (Svensson, 2009).
Under this framework, the Consumer Price Index (CPI) based inflation is
targeted to be
below 6 per cent in January 2016
4 per cent for 2016-2017 with a band of +/- 2 per cent.
Further, subject to the establishment and achievement of the nominal anchor
in terms of an inflation target, monetary policy conduct is expected to be
consistent with a sustainable growth trajectory and financial stability.
Root-causes to move away from MT to FIT framework
The following integral determinants have been encountered by the Central
Bank of Sri Lanka to move away from MT frameworks, and aligning it with a
FIT framework.
MT frameworks weakening relationship between money supply
and inflation.
Given the rising volatility in money multiplier and velocity, the
role of monetary targets as a nominal anchor has become
uncertain and also complicated the Central Banks communication
strategy.
Enhanced Monetary Policy Framework in Sri Lanka

The Central Bank of Sri Lanka conducts its monetary policy within an
enhanced monetary policy framework with features of both MT and FIT
frameworks as interim arrangement.

Aspects of Enhanced Monetary Policy Frame work


Focus on stabilising inflation and growth objectives:
Entire focus is on stabilising inflation and supporting the growth objectives
and flexibility in exchange rate management.
Although the Central Bank does not announce any monetary targets
explicitly, broad money aggregates would continue to remain as the
indicative intermediate variable to guide the conduct of monetary policy.

Usage of average weighted call money rate (AWCMR)


The Central Bank is now using average weighted call money rate (AWCMR)
as its operating target instead of reserve money.
It relies on its market based policy instruments, namely policy interest
rates and open market operations.
Usage of Economic forecasting tools
Short term forecasting tools and medium term dynamic stochastic general
equilibrium (DSGE) techniques are being used to boost-up Macroeconomic
projections.
Eg: Inflation projections
Continuous actions of CBSL to enhance Monetary policy
frame work
The Central Bank would continue to take requisite actions to make required
modifications to enhance the Monetary policy frame work in line with the
growing needs of the economy as well as the dynamic global environment
in order to ensure both price and real sector stability on a sustainable
basis.

Greater emphasis is placed on market based instruments,


particularly policy interest rates and OMO, to guide AWCMR, the
operating target of the framework, along the desired path.
The monetary programme 2015 originally envisaged an annual
growth of 13.5 per cent in broad money (M2b), consistent with the
projected real GDP growth of 8.0 per cent and the expected

implicit GDP deflator of 5.0 per cent, while the average growth
was set at 12.0 per cent.
In comparison to this envisaged monetary expansion, the actual
broad money growth in 2015 averaged 15.2 per cent, although an
immediate threat to inflation was not observed due to favourable
supply conditions.

The Monetary Policy Committee (MPC) continued to assist the


Monetary Board of the Central Bank in making monetary policy
decisions.

Upgrade in Data dissemination process

The Central bank of Sri Lanka continuing efforts to upgrade its


Data dissemination process to communicate about inflation,
policies and decisions to all market participants and public in
timely manner through regular and occasional communiques,
press conferences, seminars and lectures as well as speeches by
the Governor and the senior officials of the Central Bank.

Adoption of Special Data Dissemination Standard (SDDS)


For the dissemination of economic, monetary and financial data to
the public, and to publish useful economic information the Special
Data Dissemination Standard (SDDS) of the International
Monetary Fund (IMF) has been adopted by the Central bank of Sri
Lanka.
Eg: Publish economic indicators, bulletins and macroeconomic chart pack
in all three languages on the Central Bank website.

n an environment of continued low inflation,

the Central Bank maintained a relaxed


monetary policy stance during the year,
but initiated a gradual tightening of monetary
policy towards end 2015 to preempt the
emergence of excessive demand pressures
on inflation emanating from high credit and
money expansion. As private sector credit growth
revived gradually, in March 2015, the Central Bank
removed the restrictions placed on the access

to the Standing Deposit Facility (SDF) under its


open market operations (OMO) that was in effect
since September 2014. To dampen the impact of
this adjustment on short term interest rates, the
Central Bank lowered its policy rates by 50 basis
points in April 2015.
Monetary aggregates grew
at a higher than projected rate in 2015 as a result
of the expansion in net domestic assets (NDA)
of the banking system driven by enhanced credit
flows to both private and public sectors amidst
a contraction in net foreign assets (NFA) of the
banking sector. The year-on-year growth of credit
granted by commercial banks to the private sector
accelerated to reach 25.1 per cent by end 2015
from 8.8 per cent at end 2014. Increased domestic
demand, a part of which was transformed into
high demand for imports, amidst continued low
interest rates drove the demand for credit by the
private sector. This expansion was reflected in
credit flows to all major sectors of the economy.
Given the higher than expected domestic credit
growth, several policy measures were introduced
towards the end of 2015 to contain credit flows to
selected sectors. Accordingly, a minimum cash
margin requirement was imposed on Letters of
Credit (LCs) opened for the importation of motor
vehicles, which was replaced later by a maximum
Loan to Value (LTV) ratio on loans and advances
granted for the purpose of purchase or utilisation
of motor vehicles. These measures, along with
greater flexibility allowed in the determination
of the exchange rate and the changes to the tax
structure introduced by the government, were
expected to support containing excessive growth
of personal loans and advances, and strengthen
macroeconomic and financial system stability.
Meanwhile, credit obtained by the public sector
also increased as a result of the heavy reliance of
the government on domestic sources to finance the
budget deficit in the midst of slow foreign financial

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MONETARY POLICY, MONEY, CREDIT AND
INTEREST RATES
MONETaRY POLICY, MONEY, CREDIT AND INTEREST RATES
CENTRAL BANK OF SRI LANKA | ANNUAL REPORT 2015
200

7
flows as well as the weak financial position of
certain public corporations. Excess rupee liquidity
in the domestic money market, although declined
from the levels observed in the previous year,
remained high reflecting accommodative monetary
conditions in the economy. The Central Bank
conducted open market operations appropriately to
guide short term interest rates in the money market.
Both deposit and lending rates remained relatively low
during 2015 although yield rates in the government
securities market increased responding mainly due
to the high domestic borrowing requirement of the
government, amidst the Central Banks decision
to issue government securities only through public
auctions. In the meantime, headline inflation declined
further during the year mainly as a result of downward
revisions to administered prices of key commodities,
favourable domestic supply side developments and
declining prices in international commodity markets.
Nevertheless, core inflation displayed an upward
trend since February 2015 reflecting the firming up of
demand conditions.
Although an immediate threat to price stability
is not expected, the Central Bank commenced
tightening its monetary policy stance gradually
from end 2015 in order to forestall excessive
demand pressures on inflation arising from
high credit and monetary expansion and the
continued high excess rupee liquidity in the
domestic money market. Accordingly, the Central
Bank raised the Statutory Reserve Ratio (SRR)
applicable on all rupee deposit liabilities of licensed
commercial banks (LCBs) by 1.50 percentage
points in December 2015, to be effective from
16 January 2016. This measure was expected
to permanently absorb a part of excess liquidity
from the market. Furthermore, the Central Bank
increased its main policy interest rates, namely
the Standing Deposit Facility Rate (SDFR) and the
Standing Lending Facility Rate (SLFR) by 50 basis
points effective from the close of business on 19
February 2016. Reflecting these policy changes
as well as continued demand for credit, overnight
interest rates, which remained close to the lower
bound of the policy rate corridor since March
2015, increased to the upper half of the corridor,
while yields on government securities increased
substantially and other market interest rates also
commenced moving upwards. Going forward,
amidst volatile global economic conditions and
domestic vulnerabilities, the conduct of monetary
policy in 2016 will be focused on maintaining
inflation in mid-single digits, while facilitating the
economy to realise its potential in the medium term

Money Market Liquidity


Excess liquidity in the domestic money
market declined gradually in 2015 despite
some variations observed throughout the year.
During 2015, overnight excess liquidity ranged from
Rs. 3.3 billion to Rs. 149.6 billion, and averaged
Rs. 76.6 billion, while total excess liquidity stood
at Rs. 105.3 billion by end 2015 compared to
Rs. 325.6 billion at end 2014. Excess liquidity
remained high during January 2015 due to Treasury
bill purchases and the provisional advances to
the government by the Central Bank. However,
excess liquidity started to decline gradually until
August 2015, mainly due to the continued supply
of foreign exchange to the domestic foreign
exchange market, foreign loan repayments, early
retirements and outright sales of Treasury bills
held by the Central Bank as well as high currency
withdrawals from the Central Bank, particularly
during the general election period. The decline in
liquidity was also a reflection of the utilisation of
liquidity by commercial banks to provide credit to
the economy. During the early part of 2015, the
Central Bank managed excess liquidity in the
domestic money market using overnight, short
term and long term OMO auctions. The Central
Bank also allowed all outstanding term repurchase
(repo) agreements to mature by end April 2015
and the remaining excess liquidity in the money
market was largely absorbed on an overnight basis
through the SDF of the Central Bank

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