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If inflation numbers are not realistic, the reduction in interest rates will surely discourage savings and induce consumption and for that matter, the consumption of imported goods. This is shown by the high registration of motor vehicles in the recent past, especially motorbikes where more than 1,500 motorbikes are registered per working day
In further elaborating this claim, the Bank has said that “Inflation, as measured by the change in the Colombo Consumers’ Price Index (CCPI) (2006/07=100), which is computed by the Department of Census and Statistics, decreased from 3.5 per cent recorded in September 2014 to 1.6% in October 2014, on a year-on-year (YoY) basis, which is the lowest since November 2009”. 
The downward revision of the ‘electricity tariff by 25% supported by similar reduction in prices of LP gas, petrol and diesel’ through administrative decisions by the government in the last two months have been the main reasons for this decline in the cost of living, according to the Central Bank. Since the items under reference together with rent on houses and water bills have a high weight of 24% in CCPI, even a minor reduction in the prices can cause a substantial fall in the overall CCPI value in a particular month.
Thus, though there was a marginal increase in the food and non-alcoholic beverages in October, such increase could not influence the overall index value despite it has a share at 41% in the index. Yet, the total expenditure which a consumer has to incur in order to buy the basket of goods and services in CCPI has increased, according to values given by Department of Census and Statistics or DCS, from Rs. 49,259 a year ago to Rs. 50,070 in October 2014. However, the expenditure on this basket in September 2014 amounted to Rs. 50,881 and therefore there is a slight easing of the cost of living in October 2014.
The reductions in electricity tariff and the prices of energy are not repeatable every month. Hence, a repeat performance of this beneficial outcome in the coming months is unlikely.
Can the Central Bank be happy about the development?
Should the Central Bank be happy about this development? For two reasons, it should be a little more restrained in expressing its happiness. One is that it does not go along with the Central Bank’s co-objective of ‘economic and price stability’. The other is that it portends a bigger long term problem now know as ‘lowflation trap’.
Central Bank’s new mandate is to have both economic and price stability
Let’s now turn to the first issue. In an amendment done to the Bank’s governing legislation known as the Monetary Law Act in 2002, the Bank’s objective of maintaining a stable general price level in the economy was re-designated as ‘economic and price stability’. This is somewhat peculiar because in all other central banks, it is just maintaining price stability. Why this was done in the case of the Central Bank of Sri Lanka was explained in detail by this writer in a previous article in this series under title ‘Central Bank’s Mandate is to attain both economic and price stability’ (available at: http://www.ft.lk/2011/10/10/central-bank%E2%80%99s-mandate-is-to-attain-both-E2%80%98economic%E2%80%99-and-%E2%80%98price%E2%80%99-stability/). 
The broadening of the mandate to economic and price stability was due to the foresight of the then Governor of the Bank, A.S. Jayawardena, popularly known as AS. When the World Bank, IMF and even this writer were opposed to the particular term, AS had a simple but a very cogent explanation. He said that what a central bank should seek to achieve is the stability in the overall macroeconomy and not a mere price index. Because, according to him, a price index can be manipulated to record a slower growth through price controls, subsidies or mere price reductions done administratively. Such measures will definitely ease the burden of cost of living. But they will not help a central bank because those actions create imbalances elsewhere making it difficult for a central bank to attain its objective of maintaining a stable economy.
The purpose of adding the term ‘economic’ is, therefore, to remind the future central bankers that they should not be happy about a mere decline in the consumers’ price index. They should be happy only when such decreases have come from the monetary policy actions taken by the Bank without creating imbalances elsewhere in the economy.
Reduction of prices of loss makers creates issues for the fiscal sector
The current reductions in electricity tariff and prices of LP gas, petrol and diesel through administrative measures do not fall in line with the above economic wisdom. Except LP gas, the other three product supplying businesses in Sri Lanka are running at a massive loss as documented by the Committee on Public Enterprises or COPE in its recent reports to Parliament. Accordingly, the cumulative losses of the electricity supplier, CEB, during 2011-13 had amounted to Rs. 47 billion and those of the fuel supplier, CPC, had amounted to Rs. 193 billion.
These losses have to be recouped by the Treasury by raising funds either through increased taxation or by borrowing. What the Treasury has done in the past to make good these losses is to issue special Treasury bonds to these institutions which the public has to repay on a future date by paying more taxes or foregoing existing public services. Thus, there is already an imbalance in the fiscal sector of the country. Hence, the current price reductions involving loss-making public enterprises and thereby worsening the fiscal imbalance are not a development about which the Central Bank could be happy if it follows its mandate properly.
Lack of credit growth despite inducements
Sri Lanka has experienced a deceleration in the growth of its consumer price index, CCPI, from around late 2009. The long term inflation shown by this deceleration became a single digit number and that single digit number too started falling over the years. What is shown as 1.6% growth in CCPI in October 2014 during the last 12-month period is the lowest value of the single digit number ever recorded in the last five years. Responding to the decline in the single digit number, the Central Bank commenced relaxing its monetary policy with an announced objective of supporting the government’s economic growth initiatives. This was done in a number of rounds in different forms.
Credit expansion in the economy was promoted explicitly by the Central Bank by releasing a substantial amount of money which commercial banks had to keep with the Central Bank as a compulsory reserve – known as the Statutory Reserve Requirement or SRR – in July 2013 by reducing the required ratio from 8% to 6%. The amount so released was about Rs. 590 billion which if banks had used for credit expansion would have generated additional loans of Rs. 2,950 billion by about December 2014.
But this did not happen. Credit to private sector increased only by Rs. 21 billion between July 2013 and July 2014. In fact, credit to public corporations declined by Rs. 37 billion over this period. Even the lending to government by commercial banks did not increase appreciably; it increased only by Rs. 53 billion after the changes in government deposits with commercial banks are netted off. Despite the reported high economic growth of over 7% during this period, obviously the private sector did not wish to utilise bank credit for financing their activities.
Thus, in a desperate attempt to push credit to the economy, the Central Bank commenced lowering interest rates by cutting its rate on excess money deposited by commercial banks from 7.5% to 6.5%. Average fixed deposit rates of commercial banks fell from 12.38% in October 2013 to 8.09% in October 2014. Between September 2013 and September 2014, the average lending rates of commercial banks fell from 15.52% to 12.98%. Despite the cut in interest rates, commercial bank credit flows to the economy did not increase by the magnitudes by which they should have increased. It just appeared that the fall in lending rates of commercial banks was not a sufficient inducement for borrowers to raise money from banks.
A country in a lowflation trap
This situation evidences that Sri Lanka is caught up in a ‘lowflation trap’, a malaise currently being experienced by EU countries. When the inflation rate comes down sharply and holds at those low levels for some time, there should be a faster reduction in lending rates to generate a decline in real lending rates – the necessity for inducing borrowers to use bank credit.
When the average inflation rate was at 23% in 2008, the average lending rates of commercial banks were around 20%, yielding a negative real lending rate in the economy on average. It is a substantial inducement for borrowers to borrow. But when the inflation rate fell, lending rates of commercial banks did not fall in the same fashion. Accordingly, when the average inflation rate was around 7% at end-2013, the average lending rates of commercial banks stood at 15%. The real interest rates in terms of these numbers were substantially positive at about 8% – surely not an inducement for borrowers to seek funds from commercial banks. By September 2014, on the insistence of the Central Bank that commercial banks should cut their lending rates, the average lending rate fell to about 13% but inflation had fallen more sharply to 3.5% by that time. Thus, the real interest rate had increased to 9.5%.
In October 2014, the situation has become much more critical: Inflation rate has fallen further to 1.6% increasing the real lending rates to over 10%. In this situation, banks cannot be blamed for not giving loans to customers since customers have no incentive to seek bank credit at high real interest rates.
To cut or not to cut interest rates?
If inflation rate remains below 3% over the next two to three years, Sri Lanka cannot get out of the lowflation trap unless it cuts its interest rates drastically by about 5 to 6%. This means Central Bank’s standard deposit rate should be around 1%, its standard lending rate around 2%, 1-year Treasury bill rate around 2%, commercial bank deposit rates around 3% and commercial bank lending rates around 6%. But that will create serious imbalances across the economy thereby frustrating Central Bank’s attempt at attaining both economic and price stability. It may solve a problem in one area but it may create many more problems in other areas. In other words, an artificially driven-down inflation rate will not support the Central Bank to maintain macroeconomic stability across the economy.
A low interest rate regime at around the levels mentioned above is not feasible in Sri Lanka due to three reasons.
CCPI numbers coming out of a black box
In the first place, there are issues about the credibility of the inflation numbers released by DCS. Since the whole process of preparing CCPI is not subject to a post-audit verification by a technically competent authority, the numbers are just released by DCS from out of a black box. What is happening inside the black box is not visible to anyone. For instance, in October 2014, one of the reasons adduced for the decline in CCPI has been the so called reduction in electricity tariff. But the actual electricity bills received by consumers for the month of October did not show such a reduction. In the case of this writer’s monthly electricity bill, per unit tariff for 200 units had increased from Rs. 21.25 in September 2014 to Rs. 23.91 in October 2014.
It is not clear whether DCS had taken into account the actual electricity bills paid by the group of consumers represented in CCPI – the first 80% of the expenditure units in Colombo and suburbs – or just gone by the announcement made by the government. Thus, the ordinary public appears to be harbouring the belief that the CCPI numbers released by DCS are far from reality.
In such a scenario, the demand for higher wages, salaries, allowances and fees cannot be avoided. Many of the reliefs given to the public in the Budget 2015 – increase in the salaries of public servants, requesting the private sector do the same, increase in the Mahapola scholarship allowances, payment of a special subsidy to senior citizens on their savings with banks – have been made in recognition of the elevated cost of living despite the deceleration in inflation rate as calculated by DCS.
Artificially-low interest rates will worsen the external sector imbalances
Second, if inflation numbers are not realistic, the reduction in interest rates will surely discourage savings and induce consumption and for that matter, the consumption of imported goods. This is shown by the high registration of motor vehicles in the recent past, especially motorbikes where more than 1,500 motorbikes are registered per working day. Hence, a low interest rate regime is like giving a blank cheque to someone as far as consumption and imports are concerned. Despite the deceleration in the growth of imports and better performance in exports, this year’s trade deficit is likely to be around $ 8 billion. Thus, a blank cheque by way of lowered interest rates will worsen the existing imbalance in the external sector requiring the country to borrow more to fill the gap.
Low interest rates not good for foreign hot money
Third, Sri Lanka has relied on foreign hot money to build its foreign reserves by permitting foreigners to invest in high yielding government paper. Such funds, amounting to $ 3.5 billion as at end October and accounting for about 40% of total official foreign reserves, have been attracted by Sri Lanka mainly by offering higher yields on government securities when in the home countries of those investors, the maximum yield receivable has been around 1%. This incentive will be narrowed and finally be negative if Sri Lanka reduces its interest rates to a low level. In such a scenario, the outflow of these funds cannot be avoided worsening the current imbalance in the external sector. It will put pressure on the rupee to further depreciate with adverse consequences on Sri Lanka’s future growth plans.
In view of the lowflation trap in which Sri Lanka is now caught, the decline in the rate of growth in CCPI is not a development about which the Central Bank can be happy at all.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)
