Transcript Slide 1

Presentation by
Ajith Nivard Cabraal,
Governor,
Central Bank of Sri Lanka
at the
Ceylon Chamber of Commerce
Annual Sessions
on 2 July 2008
Managing Inflation, Interest Rates and
Exchange Rates:
The Balancing Act
1
Background to Presentation …….
 The Ceylon Chamber of Commerce (CCC) has asked the
Governor of the Central Bank to speak about “Managing
inflation, interest rates and exchange rates: the Balancing
Act”, at their Annual Sessions this year.
 It is significant that the CCC realizes that this is a balancing
act, and that these variables have to be balanced!
 This is a good opportunity to examine these issues closely.
When we do so, we would probably see that there are several
conflicting objectives that need to be balanced
simultaneously, when managing an economy.
2
What are these Variables?
 Let’s initially discuss with the variables that the CCC has requested
us to concentrate upon.
 Thereafter, let’s examine the other major macro-economic
fundamentals that are also imperative.
 There are hundreds of important variables, but we will, today,
examine some of the key variables only.
3
Let’s start with Inflation
 No one likes inflation. Everyone likes:
-
low and stable prices
-
better standards of living
-
higher wages, incomes and profits
-
higher purchasing power
-
wider choices
 But, the globalized economy is continuously subject to demand and
supply shocks, local and external.
 Therefore, it’s not easy to maintain stable price levels.
 It’s also not easy to compare inflation across countries because of
different consumption patterns, methods of computation,
expenditure bases, etc.
4
What is Inflation and what causes it?
 Inflation is simply defined as the continuous increase in the
general price level.
 In the long-term, inflation is a monetary phenomenon. Demand
driven inflation is caused by monetary expansion and the
Central Bank has control over the demand-driven inflation.
 In the short-term, inflation is also affected by supply
conditions. Supply driven inflation has to be contained through
increased production and productivity.
5
How has Sri Lanka fared with Inflation?
 Not too well. Our average inflation over the 30 years
(1978-2007) has been 11.7%. In many other countries, it is
well below this level.
Average Inflation
1978-2007 – 11.7%
30
25
per cent
20
15
10
5
0
1,9 7 8
1,9 8 1
1,9 8 4
1,9 8 7
1,9 9 0
1,9 9 3
1,9 9 6
1,9 9 9
2 ,0 0 2
2 ,0 0 5
 Today, the moving monthly average inflation is 21%.
6
How is the World coping with Inflation today?
•
The world commodity and oil prices have soared, surpassing
everyone’s imagination. Inflation in many countries have
almost doubled:
Chi l e
Saudi Ar abi a
USA
Russi a
M al aysi a
T ai wan
South Kor ea
Chi na
Indi a
T hai l and
Si ngapor e
Indonesi a
Phi l i ppi nes
Hong Kong
Vi etnam
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
Latest Year Ago
7
Have we done anything about it?
 Monetary policy in 2007 and 2008 has been the tightest ever
when compared with the policies over the past several decades.
Tight reserve money targets have been announced and achieved.
 Interest rates have risen considerably as a result. Growth in
credit has also slowed. Demand has thereby decelerated.
 But, owing to supply shocks, both local and global, inflation has
been persistently rising.
8
What does tight Monetary Policy do?
 For a start, it decelerates demand, and consequently
moderates inflation. But, over time, due to the
interest rate increase, business activities suffer.
 With the resulting credit decline and demand
deceleration, growth decreases and other benefits
that arises from growth, get affected.

That’s the adverse side-effect that arises when
administering tight monetary policy to deal with the
inflationary conditions.

So, the objective should be to contain inflation
without killing growth.
9
What’s the background to Interest Rates?

Interest is a consideration that is paid for the
use of capital. Demand and supply of capital
will determine the interest rates.

Interest rates have to be kept high when
inflation is rising in order to reduce liquidity
and thereby curtail demand. By doing so, the
tendency for price rises is curtailed.
10
What are the repercussions of
Interest Rates increasing?
 Low interest generally spurs growth and credit expansion, while
high interest tends to suppress growth tendencies.
 Therefore, interest rates have to be kept high only until inflation
moderates. Thereafter, interest rates could be allowed to decline.
 Here again, we have to strike a balance with the conflicting
variables judiciously.
11
The Exchange Rate
 The exchange rate is determined by the demand and
supply of foreign currencies into the economy.
 Inflows take place as a result of (a) exports, (b)
inward remittances, (c) capital flows and (d) loans.
Outflows takes place as a result of (a) imports, (b)
loan repayments, (c) capital transfers and (d) interest
payments.
 If inflows are higher than the outflows, the local
currency would appreciate. If not, the local currency
would depreciate.
12
How have we managed the Exchange Rate
all these years?
 The trade deficit and current account deficit has been
generally dealt with a gradual or sometimes steep
depreciation of the SL Rupee.
 For the last 50 years, Sri Lanka has been managing its
economy on the basis that the Sri Lanka Rupee should
depreciate its value vis-a-vis other currencies.
 Very little has been done to address this issue on a long
term basis with a clear policy of improving productivity.
13
What happened to the Exchange Rate?
E xc hange Rate De pr e c i ati on (ye ar -on-ye ar c hange ) agai ns t US$
19 5 2
19 5 7
19 6 2
19 6 7
19 7 2
19 7 7
19 8 2
19 8 7
19 9 2
19 9 7
2002
2007
5
0
-5
-10
-15
-20
-25
-30
-35
-40
-45
 On average, the SL rupee depreciated by 5.9% during 2001-
2004. In 2005, the SL rupee appreciated by 2.4 % due to
tsunami inflows and the unsolicited debt moratorium. In 2006,
the depreciation was 5.2%
 In 2007, depreciation was 0.9%, and so far during the first half
of 2008, the rupee has appreciated by around 1.0 %
14
What has been the Impact of our Past Policy?
 We have generally assumed that it is good to allow the exchange
rate to depreciate in order to allow our exports to be
competitive, and to discourage imports. Maybe, this happened.
This was also a prescription of the IMF and WB for the Exchange
Rate management. But, what else happened?
 Out of our external public debt of Rs.1,295 billion as at 31st
March 2008, Rs. 620 billion or 48% or nearly US$ 6 billion of
external debt has arisen only due to the rupee depreciation. In
fact, a huge additional debt burden has been “created” without a
corresponding asset.
15
The Depreciation Factor…
 The artificial “creation” of debt as of now amounts to more than
the entirety of last year’s government revenue.
 It is also enough to:
•
construct 15 Hambantota Ports, or
•
construct 30 Southern Highways, or
•
Pay the entire Government salary and pension bill for 2
years!, or
•
Pay the salaries of the entire armed services for 10 years.
 Let’s take a look at 2 case studies..
16
Case Study 1 – Colombo International Airport Development Loan (1981)
JY(m)



Amount borrowed in 1981
=
Total payments up to March’08
=
Loan Repayments
=
Interest Payments
=
Remaining balance as at end March ’08
SLR(m)
10,190
917
5,377
7,208
3,989
1,388
=
2,982
3,219
 Even if the government borrowed Rs 917 m from domestic market at
an interest of 20%, and paid interest for the last 27 years, it would
have amounted to Rs. 4,769 m, plus the loan repayment of Rs.917
m. totalling Rs. 5,886 m.
 Compare such sum with the payments of Rs. 5,377 m made so far
plus a sum of Rs.3,219 m. still due- a total of Rs.8,596 m. The
additional cost is Rs. 2,710 m!
17
Case Study 2 - Supply of Wheat under PL 480 (1979)
USD(m)

SLR(m)
Amount Borrowed in 1979 for
90,000 Metric Tons of wheat flour
(Sufficient for approx. 130 m loaves of
=
16.2
252.3
=
18.5
1,119.5
Loan Repayments
=
9.9
651.6
Interest Payments
=
9.1
467.9
=
6.3
676.4
bread or 10 loaves per person)


Total payments up to March’08
Remaining balance as at end March ’08
 Even if the government borrowed Rs. 252.3 m from the domestic
market in 1979 at an interest rate of 21 per cent, the total
payments so far would have been sufficient to settle the entire
loan!
18
It is clear that we must
re-visit our Exchange Rate Policy…
 Instead of waiting for the exchange rate to depreciate and then
for our businesses to become competitive, it is time for all of us
to improve our productivity in whatever manner we can.
 Obviously, it is the time to revisit our exchange rate policy.
19
Now,
Let’s Look at
a Few More Variables…
20
The frequently forgotten Productivity…
 Many countries developed when their productivity
levels improved. As a result, their currencies enjoyed
an appreciation vis-a-vis their main trading partners.
That was the tough path.
 Sri Lanka took the easy path of allowing the SL rupee
to depreciate with the hope that exporters would
benefit and hopefully, importers would get discouraged.
21
To what extent should we improve our Productivity?
 We must increase our productivity levels by at least 7-10 per
cent per annum at all levels of management and activities for the
next 5 years for the 1.2 million government and approximately 6.0
million private sector workforce.
 If we do so, we can comfortably maintain the exchange rate at the
current levels and lessen the impact of imported inflation.
22
In which areas can we improve Productivity urgently?
 Increase our milk production from the present 200 million litres to
1 billion litres (75% of the country requirement). Increase our
sugar production from 55,000 metric tons to 350,000 metric tons
(60% of the country requirement)
 If we produce these basic food items domestically, we can save at
least US$ 250 million and help our exchange rate to maintain
value.
 We have an EEZ 8 times larger than county’s land area. This is an
area with enormous economic potential.
23
How is our
Growth Track Record?

Every country has to record a reasonable economic growth as
otherwise the economy would quickly stagnate.

Growth should be country-wide and reach all sections of the
population.

Sri Lanka has had an average growth of 4.2% from 1950 – 2004, and
the average growth for the past three years has been 6.9%.

This has helped us to now reach a per capita income of US$ 1,615.
24
Growth at any Cost?
 Growth, if too fast, can over-heat the economy, while growth, if too
slow, can lead to stagnation and political unrest. So, growth also
needs to be managed with the rest of the macro-economic variables.
 At the same time, regional disparities need to be addressed and
strategies for balanced regional development should be
implemented.
 That is why mega projects on a provincial basis, and village-based
projects on a micro basis, have to be implemented simultaneously.
 It is imperative that we allow the growth momentum to continue,
without interrupting it too severely.
25
Poverty and Unemployment
 Poverty has reduced from 22.8 per cent in 2002 to 15.2 per cent
in 2007. Unemployment has reduced from about 12 per cent in
1995 to 5 per cent in 2007.
 However, there are still several districts where the poverty levels
are unacceptably high.
Falling unemployment rate (%)
14
12
10
8
6
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
4
26
How can we maintain the momentum of reducing
Poverty and Unemployment?
 It is essential that poverty levels are reduced at a fast pace with
perhaps a target of reducing the level to not more than 5% by the
year 2015.
 Lower unemployment will help minimize disparities. The
realization of such an outcome needs more growth and investment.
 That is why growth and investment (both public and private)
cannot be compromised too much, even in times of high
inflation.
27
The Challenge of Managing the
Public Debt

As at 31 December 2007, the public debt stock
stood at Rupees 3,070 billion. That’s about Rs.
153,500 per person.

Our debt to GDP ratio declined to 85.8 per cent at
end 2007 from 88.7 per cent in 2006.
2006
2007
Domestic Debt/GDP%
50.3
47.9
Foreign Debt/GDP%
38.4
37.9
28
Maintaining Public Debt prudently
while promoting new Instruments…
 We have to be careful in raising the public debt stock,
even though we have to depend on debt finance to
cover the resource gap in the country.
 That is why it is important to move towards private
public partnership. We have now removed many
shackles. The private sector must now respond to this
challenge and access the worldwide capital and debt
markets so that they could participate in the large
projects themselves.
29
The new thrust in
Infrastructure Development …
 Sound infrastructure is vital for high growth.
 Today, we have an unprecedented infrastructure
development initiative that is being implemented.
 The work-in-progress on infrastructure development
amounting to nearly US$ 5 billion is much more than at
any time in the history of our country.
30
Mahinda Randora—New Infrastructure Development
Initiative covers the entire Country
31
Keeping the Infrastructure Development going is vital
for future growth
 A sound infrastructure, serves to attract foreign and local
investments - more than tax relief and other benefits.
 Sri Lanka has still a long way to go in bringing infrastructure up to
the level of countries which enjoy per capita incomes of US$ 3,500
to 4,500.
 This infrastructure development momentum has to be
continued at the same pace or at a higher pace for at least the
next 10 years, both at a national level and a village level.
 High interest discourages investment in infrastructure. That is why
we are opening out access to capital from international markets to
the private sector as well.
32
Maintaining Financial System Stability
 While balancing the other macro-economic variables, we have to
maintain financial system stability too..
 That is the health of financial institutions, infrastructure,
instruments, and products.
 Poor governance in Banks and other financial institutions have
lead to collapses in other countries. We should learn from
others’ mistakes and be very wary.
 We also have to quickly improve corporate governance of
financial institutions, and ensure that the general public has
confidence in the financial system.
33
National Security, Food Security
and Industrial Harmony

The fine balance in the economy can easily get disturbed if
there is any national security issue, food security issue or a
spate of industrial disputes.

A country has to allocate sufficient resources for national
security, so as to provide a safe environment.

Food security is a human issue, which is beyond cost and price.
If there’s food insecurity, it will affect the overall social
stability.

Industrial harmony actively supports economic activities.
34
Now… let’s talk about the Balancing Act !
 In cricket, we cannot concentrate only on batting. We also have to
capture wickets and take the catches. It is a balance.
 In the same way, all macro-economic fundamentals have to be
balanced at the same time. We cannot focus only on one aspect
only while ignoring others.
 Trying to infuse experiences of other countries, however
successful, without reference to the local conditions, is
sometimes detrimental. By all means, let’s understand the
principles of success of other economies, analyze the logic of
successful strategies. But, let’s implement in Sri Lanka, policies
that would succeed in the Sri Lankan political, economic and
social frameworks.
35
Ooops… The “Shaky” Platform !
 Balancing with many variables is not easy.
 The Balancing Act is made even more difficult, if while all these
macro economic fundamentals are being managed and balanced,
the platform itself is unstable.
 Let’s look at a few of these “de-stabilising” factors.
36
Terrorism –
international and local
 Terrorism is posing tremendous challenges to Sri Lanka and
the world.
 There is an economic cost for the war against terror. But,
what is the long-term solution?
 A country has to respond to terrorism both militarily and
politically.
 Recent events show that such a response will yield longterm favourable returns. The liberation of the Eastern
Province from the LTTE is a very good example.
37
Highest ever Food Prices!
CCPI Food Index
(2002=100)
FAO Food Price Index
(1998-2000=100)
220
220
200
200
2007
180
180
2007
160
160
2006
140
140
2006
2005
120
120
2005
100
100
J
F M A M
J
J A
S O N D
J
F M A
M
J
J A
S O N D
 Now, the entire world faces an unprecedent shock from the
very high food prices.
 As a result, many developing countries are now facing very high
inflation.
 The problem is not unique to Sri Lanka…
38
Worldwide Economic Turmoil
is continuing…

Capital and debt markets are still grappling with “sub-prime” and
other credit qualifying issues.

The US is struggling to avoid a recession.

The slow down in the US economy has affected the growth in almost
every country, including the emerging economies of China and India.

These unsettled economic conditions increases the risk and
uncertainty faced by countries like Sri Lanka as well.
39
The Negative Publicity Machines…
 Some groups with vested interests misguide the general public
and investors deliberately.
 They constantly publish lies, half-truths and biased analysis to
discredit the country and economy, and diminish confidence.
 Some of the misinformation is carried out by politicians wearing
economic cloaks!
40
Unprecedented Oil Prices
are still on the rise !
International Crude Oil Prices - Monthly Average
US$/bbl
140
120
100
80
60
40
20
0
2003
Jan
July
2004
Jan
July
2005
Jan
July
2006
Jan
July
2007
Jan
July
2008
Jan
Brent
• Oil prices have increased almost 5 fold since 2003. Some analysts
project that it will hit US$ 200 per barrel during the year!
• High oil prices severely challenges price stability, cost of
industrial production as well as the health of the external sector.
• People making estimates based on oil prices, are having
nightmares !
41
What is the Answer?
 Obviously there is no single right answer.
 There is also no right solution, that will deliver optimum
values to each of these macro-economic fundamentals.
 A policy initiative to deal with one variable could very well
have adverse implications on another, even to the extent of
negating the estimated benefit completely.
 The challenge before us is to balance these many competing
factors in a rational manner to deliver short-term successes
and long-term optimum results.
 That certainly is a tough proposition...
42
But … Some say it is easy !
 Yes. It is easy for a person who is only dissecting or analysing one
of the variables to find fault and offer good advice to deal with
that aspect only.
 Very often, they do not see the implications of such suggested
actions on other variables.
 It is rare for such persons to see and understand the “big picture”.
43
Managing the Economy in Turbulent Times
is like managing a difficult Patient
with multiple ailments !
 Sometimes, administering a very good drug that is needed to
manage a particular condition of the patient could have
disastrous side effects because of another ailment that the
patient is suffering from.
 A good physician would administer drugs for the different
ailments with caution, care and concern, so as to manage the
several ailments simultaneously, without harming the patient
permanently, and, in that manner, lead him to good health and
well-being.
44
Managing the Economy
in Turbulent Times is also like juggling on a
Shaky Platform !
 The trick is to keep all the balls in the air without
dropping any.
 When the platform is itself shaky, it will be tough, but
the goal is to keep going.
45
Can we have Hope?
 Of course.
 It is not easy, but, it can be done.
 The last two years have been unprecedented in its
challenges.

We have shown that it is possible to survive and
grow even in these adverse circumstances, if we
keep going and work on our strengths.
GOOD LUCK TO ALL OF YOU !!
46