Sept 25, 2010 (LBO) - The International Monetary Fund has released 212.5 million US dollars to Sri Lanka under its 2.5 billion US dollar program, backed reform proposals and suggested that the central bank move away from its quantity targeting monetary framework.
"Further improvements in monetary policy formulation will provide useful support for macroeconomic stability," Murilo Portugal, deputy managing director and acting chair, said in a statement.
Consumer inflation in Sri Lanka's capital Colombo was up 5.0 percent in August, from an year earlier. Given the central bank's historical record of double digit inflation, such a number is not considered bad in Sri Lanka.
Peg and base money targets
Sri Lanka maintains a tight peg with the US dollar, but trying to maintain a peg and have independent monetary policy (print money) has resulted in high inflation and balance of payments troubles for the country since shortly after the creation of the central bank in 1950.
Since 2007 Sri Lanka has maintained a quantity targeting framework to bring down inflation which hit 29.9 percent in April 2008, after which a controversial new inflation index was also introduced.
Liquidity shortages during a balance of payments crisis later in the contracted reserve money beyond targets. Credit contracted both in Sri Lanka and in the US to whose currency the rupee is pegged. Inflation plummetted.
At the time the Central Bank used quantity targets for reserve money (the narrowest form of money through which all final transactions in an economy are cleared) as the key operating target rather than interest rates, with inflation as a final or rather 'indirect' target.
But to directly target inflation with just policy rates Sri Lanka has to abandon both intervening in forex markets and intervening in the primary treasury bill markets.
Such interventions generate liquidity outside open market operations and undermine the overnight policy rates mechanism.
Sustained T-bill purchases will eventually create higher inflation than the anchor US currency, whose inflation serves as a floor under an exchange rate peg.
Rate Targeting
In 2010 there was less emphasis on quantity targets and more reliance on rates. Reserve money targets have been relaxed from the original already in 2010 under revised IMF agreements.
"The central bank is now in a position to move gradually toward a flexible framework that targets inflation more directly," Portugal said.
"The recent introduction of more exchange rate flexibility will support such a transition while also helping to maintain competitiveness."
Concerns have been raised by exporters about the increasing overvaluation of Sri Lanka's rupee against competitors. By June 2010 the rupees was 25 percent 'overvalued' as measured by the real effective exchange rate index.
Despite higher-than-US inflation, Sri Lanka has also pushed the exchange rate up. It can be easily done because with a 7.5 percent floor on interest rates, which is substantially higher than the US liquidity allows liquidity to be drained easily, before or after creating inflation.
With the release of the latest tranche of cash, the IMF said the total given to Sri Lanka under its 2.6 billion US dollar program would increase to 1,274 million US dollars.
But Sri Lanka now has 5.7 billion US dollars in foreign reserve, far above a base money of around 3.0 billion US dollars and foreign reserves are no longer a problem.
But local analysts, rating agencies, foreign lenders and investors look to the IMF program to minimize state excesses and keep the economy stable.
Balancing a runaway budgeting, which is the key trigger of high inflation and balance of payments troubles remains a key to the program.
"Fundamental tax reform, including reform of the investment promotion regime, is central to achieving the government’s budget deficit reduction targets while creating the fiscal space for much-needed reconstruction and infrastructure investment, as well as social spending," Portugal said.
"In this regard, the 2011 budget will be key to demonstrate the government’s continued commitment to the program’s goals."
Growth Facility
The so-called 'stand by' (emergency) program which was initially started to boost foreign reserves which fell to 1.2 billion US dollars has now take a more reform oriented 'poverty reduction and growth facility' type of track with authorities keen on reforms.
"Overall economic conditions are improving, and the economy is likely to show strong growth this year on the back of improved fundamentals and political stability," Portugal said.
"Sustaining high, socially inclusive growth will require substantially higher levels of private investment, underpinned by broad-based structural and financial sector reforms."
The central bank has upgraded Sri Lanka's growth this year to between 7.5 to 8.0 percent, one of the highest in the world.
"Overall economic conditions are improving, and the economy is likely to show strong growth this year on the back of improved fundamentals and political stability," Portugal said.
"Sustaining high, socially inclusive growth will require substantially higher levels of private investment, underpinned by broad-based structural and financial sector reforms.
"The current favorable environment allows the authorities to focus on addressing the many challenges that remain, particularly in the fiscal and financial sectors.
"Policies will be geared toward preserving macroeconomic stability, ensuring external competitiveness, facilitating capital market development, and improving the investment climate."
source - www.lbo.lk
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