Central Bank responds to ‘Dilemma in Monetary Policy: Monetary Board caught in ‘The Devil’s Alternat

The attention of the Central Bank of Sri Lanka has been drawn to an article that appeared in Daily FT on 4 April, written by Mr. W.A. Wijewardena (WA), a retired employee of the Central Bank of Sri Lanka. 

The article alleges that the Monetary Board of the Central Bank of Sri Lanka (hereinafter CBSL) should have tightened monetary policy at the meeting held on 29 March 2016. Although the CBSL is of the view that the regular Monetary Policy Review issued on 29 March 2016 sufficiently explains the monetary policy stance of the CBSL and summarises the factors that were considered in arriving at the decision, the following response is issued for the benefit of the general public, who could be misguided by WA’s partial analysis.

According to WA, “in spite of the market expectation of tightening monetary policy, which was based on the logical economic choice which the Board would have made to lift the economy out of the prevailing foreign exchange crisis, the CBSL chose to continue the prevailing loose monetary policy stance with low interest rates”.

WA is seemingly unaware that the CBSL has tightened monetary policy, first by raising the Statutory Reserve Requirement (SRR) in January 2016, followed by increasing the main policy interest rates of the Central Bank by 50 basis points in February 2016. These monetary policy actions were implemented in addition to the measures put in place in the last quarter of 2015 by the CBSL and the Government, including the imposition of a loan to value (LTV) ratio on motor vehicle related credit facilities, the allowing of the exchange rate to depreciate, and the changes introduced to vehicle import duties. The monetary policy measures taken in early 2016, along with the declining rupee liquidity levels in the domestic market, resulted in most market interest rates increasing substantially. 

WA’s argument throughout the article, that the CBSL appears to be under the impression that low interest rates would stimulate the economy is flawed, considering the policy actions already taken, the observed increase in market interest rates, and the fact that, not only in nominal terms but also in real terms, the increase in market interest rates has been substantial. The decision of the CBSL in March 2016 to maintain the monetary policy stance unchanged after two consecutive months of tightening is a logical step in allowing sufficient time for the market to respond to monetary policy actions while allowing room for the already increased market interest rates to stabilise.

WA further states that the Monetary Policy Review issued of March 2016 is ‘like a pre-obituary notice’. The CBSL is of the view that the Review is an accurate representation of facts on prevailing economic conditions and explains the expected developments in relation to monetary aggregates and inflation. It is WA who writes an ‘obituary notice’ for the economy stating that “though the Board had not prognosticated, if this situation prevails, the growth in 2016 will also be a [sic] dismal”. 

The CBSL is not surprised by this premature conclusion, as WA has predicted crisis after crisis, without much success, since his retirement in 2009. WA also speaks of “assurances of the Board” with regard to external sector conditions and argues that the Board “presumably assumes that [the narrowing of the trade deficit in January] would be continued forever”.  Once again, it is sufficient to state that the CBSL has simply stated the summary of facts that were considered in arriving at the monetary policy decision, and it has not hidden the fact that there has been a decline in foreign exchange reserves, and main reasons for that decline were the debt service payments and the supply of foreign exchange to cover foreign investor sales of Government securities. It is no secret that the government and the Central Bank are holding discussions with the International Monetary Fund (IMF) at present, and successful negotiations with the IMF would help build confidence of foreign investors in the future of the economy and support the implementation of necessary structural reforms.

Furthermore, the CBSL is also of the view that interest rates alone are insufficient to address the external sector issues that the country is facing today. In the midst of the balance of payments crisis in 2000/01, the CBSL unsuccessfully attempted to prevent the exchange rate from depreciating by raising policy interest rates. Specifically, the Reverse Repurchase rate of the CBSL was increased from 13.48% in June 2000 to 23.00% by January 2001.

In addition to the free-fall WA has discussed in his article, the end result was the disastrous growth outcome in 2001, where the country registered its only negative annual real GDP growth rate since independence. The CBSL is of the view that a blend of policy measures, including fiscal and monetary policy measures, is more appropriate, rather than solely relying on interest rates to correct the imbalances in the external sector. In the meantime, the CBSL will continue to emphasise the need to implement necessary structural reforms to strengthen the fiscal and external sectors on a sustainable basis.

The CBSL finally wishes to comment on WA’s conclusion that the “Monetary Board is following the market and not leading”. This contradicts with WA’s earlier opinion that the CBSL has not followed market predictions of a rate hike in March 2016. Furthermore, in the previous month, the same poll that WA’s view is based on, predicted no change in policy interest rates. But the CBSL increased policy interest rates by 50 basis points in February 2016, which was reported by financial newspapers as a surprise decision. If the CBSL is merely following the market, there would have been no surprise decision either in February or March 2016.

The CBSL, similar to other central banks in the world, will take decisions that are based on the wide and up-to-date set of information available to the CBSL and considering the views of the Board and the recommendations of the technical staff of the bank. In this regard, the general public is also invited to pay attention to regular press conferences held by the CBSL, where the Governor and senior staff of the Bank explain the reasons behind policy decisions in detail and provide some guidance as to the future direction of monetary policy.