Evolution of Monetary and Exchange Rate Policy in Sri Lanka and the Way Forward

I am deeply honoured to have been invited to deliver the Olcott Oration 2017 and to join a list of great Anandians who have delivered this Oration before. I cannot think of a greater honour that my school could confer on me. I accepted this invitation with humbleness, with gratitude and respect, and with great pride. Let me also take this opportunity to appreciate the support and guidance I received during my school career at Ananda College. The guidance our teachers gave us laid the foundation for any success later on in our lives.


Evolution of Monetary and Exchange Rate Policy in Sri Lanka and the Way Forward
My oration today, is on the rather technical topic of monetary and exchange rate policy. The biggest challenge that I have to face is to present such a topic to an audience with a majority who might not be familiar with the technical jargon involved. However, I will attempt to keep the discussion as simple as possible.

Central Banking and Price Stability
The prime responsibility of any central bank around the world is to maintain price stability by way of maintaining low and stable inflation on a sustainable basis. At the outset, I would like to discuss why low and stable inflation is important for growth and stability of the economy.
Based on experiences of many countries and different time periods, we have seen varying levels of inflation. When countries experience hyperinflation, domestic prices of goods and services will rise every minute. In such a situation, no one will 1 I would like to note that the views expressed in this oration are my own as an economist and do not necessarily reflect the views of the Central Bank of Sri Lanka. I also would like to acknowledge the technical support received in preparing the oration from Dr Chandranath Amarasekara and his team at the Economic Research Department of the Central Bank of Sri Lanka.
want to hold the local currency, and people will rush straight from the bank to the shops to buy goods, fearing that their currency holding will lose value along the way. In fact, the banking system itself will collapse. As people lose faith in local currency, the barter system, or the exchange of goods for goods or services will become the norm, making transactions significantly more difficult. Hyperinflation will also cause adverse redistributive effects, destroying real value of middle class savings in local currency and real incomes of fixed income earners such as workers and pensioners. One can read horror stories of hyperinflation in Germany and Australia in the 1920s, and more recently in several Latin American countries and also in countries like Zimbabwe. The episode of hyperinflation in the inter-war Germany is said to have facilitated the rise of Hitler and the global destruction that followed. The famous economics author Neil Irwin, in his book titled "The Alchemists: Three Central Bankers and a World on Fire", called the Governor of the German Reichsbank at the time, the "worst central banker in history"! Let us also look at the other extreme case of price movements, namely deflation. The example that will come to anyone's mind is Japan, which underwent what was known as the "lost decade". Now it is termed the "lost 20 years"! Since early 1990s Japan experienced deflation, a continued decline in prices of goods and services. One may think that this is great! But what could be considered good for a consumer in the short-term may not be good for the entire economy, as evidenced by the experience of Japan. Since then, the Japanese economy had experienced negative economic growth, a drop in nominal GDP, declining wages and negative interest rates! Some indications of sustained growth in Japan are seen only now.
Fortunately, Sri Lanka has never experienced such episodes in the past, and clearly we want neither hyperinflation nor deflation even in the future. But what about double-digit inflation hovering around 10-20 per cent, as experienced in Sri Lanka for several decades from 1970s? Empirical evidence clearly shows that this kind of double digit inflation is bad for sustained growth. High and volatile inflation causes lenders like banks and other financial institutions to demand a higher fixed interest rate on loans to compensate for the risk that inflation will move around, thus raising the cost of finance for investment. At the same time, financial institutions need to offer higher nominal and real interest rates to encourage savers to deposit their money to mitigate the risk of high and volatile inflation eroding the real value of their savings. High and volatile inflation increases the margin between lending rates and deposits, and this high cost of financial intermediation penalises both savers and borrowers. High and volatile inflation encourages workers to bargain for higher wages. High and volatile inflation also prompts producers and sellers in the economy to add higher markups in pricing of goods and services. The combined result of this self-fulfilling cycle will be lower economic growth and higher current account deficits, depleting reserves and volatile exchange rates, and the country will end up with a commercial capitalist class of buyers and sellers of imported goods, or a class of middlemen! Then the question is, what is the appropriate level of low and stable inflation, which will result in more desirable outcomes? Most advanced economies set their inflation target in the low single digits around 2 per cent. For example, the United States and the United Kingdom desire to maintain inflation at around 2 per cent, while in the Eurozone it is below but close to 2 per cent. Australia has an inflation target of 2-3 per cent, and in New Zealand it is 1-3 per cent. Within emerging market and developing economies, the targets are slightly higher. The Philippines and Chile target 2-4 per cent, Indonesia 2.5-4.5 per cent, Brazil 4.5 per cent, South Africa 3-6 per cent, while India targets 2-6 per cent of inflation.
It must be noted here that a central bank could only effectively control demand driven inflation. Central banks could do little to address short-term disruptions to prices due to adverse domestic supply developments or unexpected international commodity price movements. However, central bank responses will be required to contain demand driven inflation, usually identified by movements in core inflation indices.

Monetary Policy Frameworks
In order to maintain low and stable, single digit inflation, central banks around the world are entrusted with the task of conducting monetary policy with varying degrees of independence. Central banks use various monetary policy frameworks, as there needs to be a mechanism to operationalise the achievement of the end objective of price stability using the policy tools given to central banks to fulfil this task.
Monetary policy frameworks differ across countries depending on country-specific circumstances such as the level of financial market sophistication, openness of the Bank did not have much leeway to control domestic inflation as the fixed exchange rate was the anchor to manage inflation. Like many other things, inflation was also more or less imported from the United Kingdom those days! This system worked well as long as Sri Lanka earned sufficient foreign exchange to meet expenditure on imports without any restriction. For example, during the periods of export booms particularly in the early 1950s, the fixed exchange rate regime worked well, as foreign exchange earnings, which arose due to external factors rather than domestic export promoting policies, were not only sufficient to meet current expenditure but also helped build up foreign reserves so that currency peg could be maintained without foreign grants or borrowings. The necessary condition for any country to maintain a currency peg with a strong reserve currency like sterling pound on a sustainable basis is the country's ability to earn sufficient foreign exchange. In other words, such a country would require a strong set of export oriented policies. In technical terminology, a country should run at least a balanced current account in the balance of payments on a long-term basis for it to be able to maintain a peg with a strong foreign currency. Economies like Japan early on, and later Hong Kong, Singapore, Taiwan and even China, given their strong export oriented policies, were able not only to generate current account surpluses on sustainable basis, but as a result, also saw the value of their currencies appreciating against major currencies like the sterling pound and the US dollar.
During the period of Sri Lanka's fixed exchange rate regime, successive governments did not pursue export oriented policies continuously. There were short episodes where policies focused on export promotion, but there were more times of policy reversals towards encouraging import substitution and inward looking polices.
From a long-term perspective, such polices were inconsistent with the need to maintain a fixed exchange rate regime. Under these circumstances, the key challenge the Central Bank had to face was how to defend the exchange rate peg amidst policies which did not promote exports. The only choice available for the Central Bank at the time was to restrict the use of available foreign reserves and impose severe exchange control restrictions. In a way, the Central Bank at the time was successful in maintaining low inflation, which is one of the key responsibilities of the Bank, but it failed to support the multiple objectives, which were often in conflict with each other, of the then Central Bank.
In addition to pursuing inward looking economic policies, successive governments also ran high budget deficits mainly to provide subsidies and various free entitlements. Such budget deficits, even at moderate levels, caused more demand for imports in the midst of weak export performance, creating continued current account deficits, while the Central Bank was required to maintain a fixed exchange rate regime. This was an impossible task for the Central Bank. As a result, the Central Bank, from time to time, either devalued the rupee or maintained a dual exchange rate along with severe restrictions on the use of foreign exchange. This monetary policy framework lacked credibility and created severe distortions to market pricing.
Meanwhile, on the global front, the collapse of the Bretton Woods system, with the United States declaring in 1971 that it would cease to redeem US dollars for gold from its reserves, challenged the system of fixed exchange rates that the global economy was used to operate in. In addition, the 1973 oil crisis caused inflation to escalate in all countries, including Sri Lanka, often resulting in a destructive wageprice spiral. In Sri Lanka, inflation increased to 14.4 per cent by December 1973, the highest level of inflation the country experienced until then during its postindependent history.
Elsewhere in the world, following the collapse of the Bretton Woods system of exchange rates, the international community was getting used to floating exchange rates, where each currency's value was determined by the international demand for the currency. This was a new normal, prior to which money has historically been based on a valuable commodity such as gold.

Post-liberalisation Monetary Policy Framework
In November 1977, Sri Lanka embarked on a major economic liberalisation move, This sharp devaluation addressed the overvaluation of the rupee observed under the fixed regime. The subsequent managed exchange rate regime allowed some flexibility to determine the value of currency largely on the basis of market demand and supply, while attempting to prevent the overvaluation of the rupee by maintaining the real value of the rupee against movements of a basket of major currencies.

The Aftermath of the Managed Float
The introduction of the managed floating exchange rate was a welcome move from Little wonder that the Central Bank of Sri Lanka started looking for a new framework to contain inflation and inflation expectations in the absence of the pegged exchange rate system.

Beginning of Monetary Aggregate Targeting in Sri Lanka
The relationship between monetary expansion in terms of the amount of money held by the public and inflation has been well recognised in Sri Lanka from the beginning of central banking in the country. However, the first mentioning of "desired monetary targets" in a Central Bank annual report in Sri Lanka could be found in Under this monetary targeting framework with a crawling exchange rate, achieving price stability proved challenging, as successive governments continued to run high fiscal deficits even after the completion of the accelerated Mahaweli scheme to finance large scale housing and road development programmes. In addition, the three decades of ethnic conflict required successive governments to spend more money on defense expenditure. In order to maintain competitiveness of the rupee, the Central Bank had to let the currency depreciate to, at least partly, compensate for the inflation differential between Sri Lanka and its trading partners under the crawling peg system. Even though this arrangement helped to alleviate the adverse impact on exports to some extent, higher domestic demand created through excessive fiscal deficits led to large current account deficits in the balance of payments, making it difficult to maintain the crawling peg without a sharp depreciation.
By Since then, the Central Bank has explicitly announced that international reserves will not be used to defend an overvalued exchange rate. Instead, the Central Bank intervention in the foreign exchange market will aim to buildup international reserves. So far during 2017, the Central Bank has been able to purchase over US dollars 1.3 billion from the market on a net basis for this purpose, and improved market confidence is shown by the limited depreciation of the currency this year.

Gradual Modifications to the Monetary Policy Conduct
Returning to the previous discussion figures, that is 11.9 per cent, must reflect average real economic growth during this period. However, real economic growth averaged only 6.0 per cent during this period. If the argument is reversed, there is a gap of 11.1 per cent between broad money growth and real economic growth. According to the Quantity Theory, this should reflect average inflation during the period, which was not the case. Even if some allowance is made for changes in velocity of money or money demand due to possible behavioral changes and financial sector development, the growth of money vs. the real growth of the economy and inflation cannot be explained for this period.
This was sufficient evidence that the strong and reliable relationship between the goal of price stability and the nominal anchor of money growth, which was essential for the success of the monetary aggregate targeting framework, has significantly weakened over time. This phenomenon was not limited to Sri Lanka, but was

Inflation Targeting as an Alternative: Lessons from Other Countries
Therefore, without a formal announcement, the Central Bank of Sri Lanka, similar to many other central banks in the world, has moved to a monetary policy framework governed by expectations and credibility, rather than by monetary aggregates or exchange rates.
In the global economy, such a monetary policy framework that emphasised the role of expectations and credibility existed, and it was known as "inflation targeting" that I briefly referred to at the beginning. First adopted by New Zealand in 1990, inflation targeting was chosen as the monetary policy framework in Canada, the United Kingdom, Australia, and Sweden in quick succession. Encouraged by the success of inflation targeting, a number of other advanced economies as well as emerging market economies adopted this framework thereafter. These countries used inflation targeting either to bring down inflation from stubbornly high levels or to maintain inflation at low and stable levels on a sustained basis.
Inflation targeting is generally characterised by an announced inflation target; an inflation forecast, which facilitates forward looking monetary policy decision making; and a high degree of transparency and accountability. According to Lars Svensson, the Swedish economist who later served as Deputy Governor of the Riksbank, this policy framework encompasses a trinity of a mandate for price stability, independence, and accountability for the central bank, which enables anchoring of inflation expectations effectively.
In practice, inflation targeting is flexible rather than strict. According to Svensson, flexible inflation targeting means that monetary policy aims at stabilising both inflation around the inflation target and the real economy, whereas strict inflation targeting aims at stabilising inflation only, with little regard to the stability of the real economy. A strict inflation targeter would be who Mervyn King, the former Governor of Bank of England, called an "inflation nutter". Most of the central banks do not only aim at stabilising inflation around an inflation target, but also put an effort into stabilising real economic variables. This effort is described by the time horizon in achieving the inflation target, which dampens the adverse impact of policies on the real economy. Therefore, an important feature of flexible inflation targeting is that the inflation rate will be on average at target, but perhaps not every month.
A key advantage of inflation targeting is that it is easier for the general public to relate to. Since inflation is well understood by the public, the inflation forecast will serve as an ideal anchor and, with improved communication, will help bridge the information gap between the central bank and the public. Reference to such a straightforward target, rather than to an elusive monetary target, will ensure increased transparency and accountability while enabling the public to understand policy shortcomings.
Global experience has also shown that in adopting inflation targeting, a country needs to fulfill several prerequisites, particularly in terms of the legal and

Road to Flexible Inflation Targeting: Where We Stand
Considering the success of flexible inflation targeting in advanced and emerging markets, the Central Bank of Sri Lanka also considered this as the best framework to be adopted in the medium-term. A number of prerequisites for the new framework Several other recent policy changes will also support the implementation of flexible inflation targeting in the medium-term. The Central Bank has implemented a more market based exchange rate policy during recent times, with limited intervention in the foreign exchange market. There has been a build-up of international reserves with minimal impact on the exchange rate. In tandem, the financial system has continued to expand whilst exhibiting resilience amidst challenging market conditions both globally and domestically. The implementation of the Basel III framework will further enhance the resilience of the financial system.
A deeper and more liquid government securities market is also a prerequisite for a smoother transmission of the Central Bank policy rate signals to market interest rates, as yields on government securities form benchmark medium to long-term interest rates. In this regard, the recently introduced system of rule based and more presented in January 2017, the Central Bank of Sri Lanka reiterated its intention to move to flexible inflation targeting in the medium-term as its new monetary policy framework. The government has endorsed this move since then, and stated in its recently released Vision 2025 policy document that "for medium to long-term price stability, the Central Bank will move towards a flexible inflation targeting regime.
They will aim at continuously maintaining low inflation while supporting economic activity and competitiveness. The government will implement the legislative and operational changes necessary." While it is heartening to note that the Central Bank and the government have agreed in principle that flexible inflation targeting is the way forward in the conduct of monetary policy, the full implementation of flexible inflation targeting by the year 2020 will require increased efforts to fulfil the remaining prerequisites for the success of inflation targeting.
It is also expected that comprehensive amendments will be made to the MLA to facilitate the transition to flexible inflation targeting, to redefine monetary policy objectives, eliminate monetary financing of fiscal deficits, and ensure Central Bank autonomy and public accountability. Amendments to the MLA are also expected to streamline the monetary policy decision making process.
Within the Central Bank, the ongoing upgrade of technical forecasting and analytical capabilities will continue, and it is expected that by 2020, the Central Bank will commence the publication of comprehensive Inflation Reports. The Inflation Report will explain inflation developments, inflation expectations, projections for inflation and other key macroeconomic variables, the assumptions behind such projections, reasons for any deviation of actual inflation developments from targeted levels, and remedial actions to be taken in the case of deviations. Such transparency and accountability is likely to enhance the credibility of the Central Bank and well anchor inflation expectations, resulting in increased economic stability and supporting high economic growth and increased international competitiveness of Sri Lanka.
Meanwhile continued commitment by the government towards greater fiscal discipline and stronger fiscal position remains key to the successful adoption of flexible inflation targeting. Therefore, the Central Bank will continue to support government's efforts to reduce the debt to GDP ratio to 70 per cent by 2020 and curtail budget deficits at 3.5 per cent of GDP from 2020. The government's intention to strengthen the Fiscal Management (Responsibility) Act is very encouraging in this regard.
In conclusion, I would like to take you back to the beginning of Central Banking in Sri Lanka. In 1949, John Exter, the founder of the Central Bank of Sri Lanka, in his "Report on the Establishment of a Central Bank for Ceylon" stated as follows: "The decision of the government of Ceylon to establish a central bank was a decision with far reaching implications for the people of Ceylon. One implication already stands out very clearly: in taking steps to establish an independent monetary system to be administered by a central bank the government has demonstrated unmistakably its intention to achieve genuine economic freedom as a corollary of the political freedom achieved a year and a half ago. It has been the endeavour of this report to propose a type of central bank which, with proper skill and understanding in its management, will establish monetary conditions in Ceylon that may make possible, as never before, the fuller use of the nation's human and material resources and a rising standard of comfort for all." History has judged us before! I will leave it up to you to judge us in future as well!