Following are excerpts of the speech delivered by the Central Bank of Sri Lanka Governor Ajith Nivard Cabraal addressing the top brass in the business world on monetary and financial sector policies for 2007 and beyond at the launch of `Financial System Stability Review 2006`.
As we mark the new year 2007, we thought it would be appropriate and timely for the Central Bank to enunciate its policies as well as the rationale, therefore, so as to enhance policy predictability and transparency. We shall also take this opportunity to indicate our policy targets and share our latest available information in relation to the economy, upon which our analysis and targets have been based.
The Central Bank of Sri Lanka was established in August 1950 under the Monetar, Law Act No. 58 of 1949, and the Act sets out two inter-dependent core objectives. These are the attainment of the economic and price stability and the maintenance of the financial system stability.
Today, the Central Bank follows a monetary targeting policy framework in conducting monetary policy to attain economic and price stability, i.e., to achieve a sustainable, low and predictable level of inflation. Such an outcome, among others, is a prerequisite to achieving sustainable economic growth and development.
The key policy instrument used in this endeavour is the establishment of policy interest rates for borrowing (Repurchase Rate) and for lending (Reverse Repurchase Rate) that operates through the Bank`s Open Market Operations.
The Central Bank conducts Open Market Operations to keep the level of Reserve money `in the system at an appropriate level, while it uses the Statutory Reserve Ratio (SRR) on commercial bank deposit liabilities to further support the monetary policy.
Financial System Stability, the other core objective of the Central Bank, is achieved through the regulation and supervision of financial institutions, the overseeing of the financial infrastructure which includes critical payment and settlement systems as well as keeping a close watch on the financial markets as a whole. To achieve this objective, the Central Bank employs a series of prudential and regulatory measures.
In addition to the core objectives, the Central Bank provides policy advice to the Government and vital state sector enterprises to strengthen macroeconomic stability and to enhance growth prospects.
The Bank also undertakes several agency and ancillary functions, which include managing the Foreign Reserves of the country, Public Debt and Employees` Provident Fund (EPF). Further, the Central Bank- plays a key role in broadening the financial infrastructure and strengthening the small, medium and micro-finance sectors in the country.
Outline of today`s
The policy statement presented today for the year 2007 and beyond focuses on several areas.
First, it sets out an account of the developments in the economy and the conduct of monetary policy and financial sector policies in the year 2006. It also presents an evaluation of the key sectoral developments in 2006, the policy measures taken and the expected impact of such measures on the country`s macro-economic environment.
Second, it examines the challenges in meeting monetary policy objectives and financial stability in 2007 and beyond.
Third, the statement provides a detailed account of the Central Bank`s monetary policy strategy in 2007 and beyond, as a major mechanism to drive the economy along a low ? inflationary/ high growth path, supported by a series of other policies and strategies.
Fourth, it discloses the policies for financial system stability in 2007 and beyond.
Fifth, it presents the identified policies for strengthening the economy through the encouragement of high savings and investment.
While we hope you would find our statement of interest, we wish to mention that, in the light of any unexpected external and internal developments, we may sometimes deviate from the strategies or targets as explained today. In such an event, we would, at that time, communicate our reasoning for such deviations for your understanding as well.
Development in the economy
As is already known, the Sri Lankan economy achieved a growth of 8 per cent in the first half of 2006, and a growth of 7.5 per cent in the third quarter of 2006. Overall, it is very likely that the economy would have grown at over 7 per cent in 2006.
These values are laudable because they have been achieved in the face of several major challenges, particularly high international oil prices and an escalation of security concerns during the year.
Notwithstanding such challenges, all major sectors of the economy grew at healthy rates.
The Agriculture sector continued its expansion with growth recorded in all sub sectors, except tea. Remarkable growth in rubber and coconut, fast recovery in the fish production, record harvests of paddy in the Maha season 2005/2006 supported the growth in the agricultural sector.
The Industry sector continued to grow, benefiting `from the rapid global economic growth and strong domestic demand. Weather, favourable to hydro-power generation, also contributed to the substantial growth in this sector.
The Services sector growth was dominated by the telecommunication services, port services, domestic and international trade, and financial services.
At the same time, however, inflation began to increase since April 2006 due to rising demand pressures in the economy. The point-to-point change in the Colombo Consumers` Price Index (CCPI), which is popularly considered as `inflation`, has been increasing since April 2006 and the CCPI increased by around 19 per cent during each of the last two months.
Although it was noted that a part of the increase was due to very high prices in vegetables, affected by extreme weather conditions, we noted with concern that core inflation too, which is a measure of inflation directly caused by demand pressures, had also risen to 15 per cent by November 2006. These pressures were somewhat aggravated by supply side developments, such as the upward adjustments in administered prices, increases in prices of some of the imported consumer items and adjustments in import tariffs applicable to some consumer food items. Such factors, of course, would essentially cause a one-time price increase and would necessarily contribute to long- term inflation only if such impact is accommodated by continuing monetary expansion.
In the meantime, we observed with satisfaction that increased economic activities had led to lower-unemployment during the year. The labour force grew by approximately 1.0 per cent to 8.1 million by end 2005 and was expected to increase further to 8.2 million by end 2006. As a consequence, the unemployment rate declined to a level of 7.2 per cent in the first quarter 2006 and to its lowest level of 6.3 per cent in the second quarter 2006.
Savings and investment, both recorded upward trends. Domestic private savings in 2006 have now been projected to increase to 19.4 as a percentage of GDP. National savings are also projected to increase, resulting from increased savings by non-resident Sri Lankans as evidenced by the high growth in migrant worker remittances.
The investment to GDP ratio is also expected to improve from 26.5 per cent in 2005 to 29.0 per cent in 2006, and private sector investment, which accounts for about 87 per cent of total investment, is estimated to increase by 31.4 per cent. Public sector investment too is projected to rise by 7.5 per cent as a result of growing construction activity in highways, roads, infrastructure facilities, community development projects, and tsunami-related reconstruction and rehabilitation projects.
The performance in the External sector improved with the continued expansion in international trade and growing global demand. During the first ten months of 2006, exports grew by 6.5 per cent and imports by 15.8 per cent with a higher growth in intermediate and investment goods. The outlay for petroleum imports increased by 29.6 per cent during this period due to the soaring oil prices. For the year as a whole, export growth is projected at 7 per cent and import growth at 15.4 per cent.
An aspect of the economy which caused some concern in the year was that the trade deficit widened to US dollars 2,955 million. As the result, the Current Account also recorded a deficit of US dollars 1,038 million in the first nine months of 2006. It reflects the imbalance between national savings and investment, which needs to be addressed by encouraging greater savings. Such Trade and Current Account deficits were financed through net inflows to the capital and financial accounts. It was also observed that Sri Lanka could reasonably and comfortably afford a bulk of the additional foreign exchange cost on account of high oil prices in the first nine months of 2006 as a result of the higher migrant worker remittances and foreign currency- denominated loans obtained by the government from external and domestic sources. Worker remittances increased by US $ 338 million in the first ten months and foreign currency denominated debt rose by US $ 404 million by end November 2006. The higher quantum of worker remittances was, to some extent, facilitated by the active promotion campaigns launched by the Central Bank with the support of the Sri Lanka Foreign Employment Bureau, overseas job agencies, foreign missions and the state banks and we believe that the impact of such initiatives would be further felt in the next few years as well.
During this year, a remarkable increase was also seen in foreign direct investments. All in all, these factors contributed towards the overall balance of payments (BOP) surplus which is estimated to exceed US dollars 150 million during 2006.
It is useful to recollect that since moving to the ``Floating exchange rate` regime in 2001, the gross official reserves have continued to increase except in 2004 when the country was hit by the sudden increase in oil prices. As of now, the gross official reserves have been sufficient to meet about three months of average imports in the recent years despite the rising expenditure on oil imports.
We also note that according to the overall policy vision announced in the `Mahinda Chintana`, the Government`s commitment to reduce the budget deficit to a sustainable level in the medium term has been made clear. In that context, the fact that the total revenue during the first nine months of 2006 increased, and thereby led to an improved Revenue/GDP ratio is laudable. In addition, it was noted that several measures were introduced by the Government to rationalise recurrent expenditure, especially adjusting domestic fuel prices to reduce the burden on the Government. Nevertheless, the Government has had to resort to borrowings from the banking sector to meet shortfalls in the face of many challenges, and in order to avoid such a situation in the future, it would be highly desirable to further improve the revenue generation and collection process in 2007 and beyond.
Another key fiscal indicator, namely recurrent expenditure as a ratio of GDP recorded a value of 14.0 per cent during this period. Capital expenditure and net lending also increased by 28.2 per cent during this period. The main contributors to this increase were the acceleration of infrastructure development and tsunami- related reconstruction activities. All in all, the overall budget deficit in the first nine months of 2006 reached 6.0 per cent of GDP, while the budget deficit in 2006 is estimated to be 8.7 per cent of GDP.
In relation to the outstanding debt stock of Government, we note with satisfaction that it is expected to decline to 93.1 per cent of GDP by end 2006 from 93.9 per cent as at end 2005. The outstanding government debt to GDP ratio is also expected to decline in the medium term in line with the path enunciated in Fiscal Management (Responsibility) Act.
We could also report that the tight monetary policy stance adopted from end 2004 was further firmed in 2006 to curtail high growth in monetary and credit aggregates to contain rising inflationary pressures. Accordingly, the Central Bank raised its policy interest rates by 25 basis points in June 2006, 12.5 basis points in July 2006, 50 basis points in September 2006, and a further 37.5 basis points in December 2006: a total of 125 basis points during the year. This is in addition to the increase of policy rates by 175 basis points during 2004 and 2005. At the same time, the Central Bank has also been conducting Open Market Operations aggressively to manage the liquidity position in the market to be within the reserve money targets.
Responding to the tight monetary policy measures adopted thus far, market interest rates have increased, thereby discouraging excessive consumption and borrowing for such purposes. In turn, this has led to a deceleration in the high growth in the money, supply. We believe that the tight monetary policy exercised by the Central Bank was instrumental in pulling back the growth in Reserve money from 20 per cent at end 2004 to 17 per cent by end August 2006. This decrease would have naturally led to a corresponding deceleration in broad money growth in the future, although in absolute terms, the growth in broad money remained uncomfortably high, around 19-20 per cent, during January to June 2006, a legacy of the high reserve money growth in the past.
In keeping with its primary objective, the Central Bank has also been very concerned about the inflationary impact of the regular use of Central Bank`s Reverse Repo window by some commercial banks which appear to use such window as a convenient instrument of regular funding. We wish to clearly discourage this practice in 2007 and therefore, with effect from 1st January 2007, the Reverse Repo facility of the Central Bank will not be made available on days when there is a liquidity surplus in the commercial banking system, according to our estimates. We would also closely monitor the banks that seek this facility regularly to ascertain whether they, are doing so because of any structural deficiencies that they are suffering from.
We also noted that the financial sector grew with increased resilience, possibly benefiting from robust economic growth and a rather favourable external environment. Profitability, capital funds and asset quality of banks improved, leading to strengthening of capacity of the financial sector to absorb shocks. In the meantime, interest rates across markets rose in response to gradual tightening of monetary policy; turnover in the foreign exchange market recorded substantial increases and market capitalisation and price indices in the equity market continued to improve.
It would also be noted in the year 2006, several important measures were taken to strengthen and improve the efficiency of the financial sector, improve risk management, enhance access to finance, strengthen the payment and settlement system as well as supervision and regulation. Banks were required to include market risk in the computation of capital adequacy to ensure that they are adequately capitalised to meet any adverse fluctuations in market prices and are not vulnerable to any unanticipated shocks. Prudential norms for classification and valuation of bank investment portfolios were further strengthened. To improve the safety and efficiency in the payments and settlements systems, the Central Bank also drafted a payment system policy in consultation with the National Payment Council to declare a public policy regarding the regulatory framework.
As is well known, the Central Bank manages the Employees` Provident Fund (EPF). It does so by receiving member contributions, maintaining member accounts, investing funds and paying benefits to members. The total assets of the EPF grew by 13 per cent to Rs. 439 billion during the 12 months ending June 2006. Total contributions and refunds during this period amounted to Rs. 16 billion and Rs. 13 billion, respectively. The total investment portfolio consisted mainly of government securities at 98 per cent, while the total income for the first half of 2006 amounted to Rs. 25 billion.
The Central Bank also manages the Public Debt to ensure that the Government`s financing needs and its payment obligations are met at the lowest possible cost over the medium- to long- term, consistent with a prudent degree of risk. During 2006, the Central Bank took several measures to strengthen the management of public debt by:
= Increasing the capital requirements, introducing a risk based supervision system and supervision activities to strengthen the Primary Dealer System and financial sector stability;
= Introducing on-line data reporting to enhance the transparency in trading government securities;
= Facilitating capacity building of market players;
= Permitting subscription upto 5 per cent of Treasury bonds by foreign investors;
= Assisting the government to raise foreign currency commercial debt through syndicated loans from the international marke;
= Developing a comprehensive debt consolidation strategy and
= Introducing a new debt instrument named Sri Lanka Nation Building Bonds for the Sri Lankan working community living abroad thereby offering them an opportunity to contribute funds towards infrastructure development in the country.