Crisis Communication

Economic Research

Inflation and Money Printing/ Exchange Rate Management

What is the CBSL doing to curtail inflation?

In order to contain the build-up of inflationary pressures and also to contain the pressure on managing the exchange rate, the CBSL commenced tightening its monetary policy stance in August 2021 by raising its policy interest rates and the Statutory Reserve Ratio (SRR) applicable on all rupee deposit liabilities of Licensed Commercial Banks (LCBs).
During the period from August 2021 to April 2022, on four occasions, the CBSL raised its policy interest rates, i.e., the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) by 900 basis points, in total to 13.50 per cent and 14.50 per cent, respectively.
The SRR was increased by 2 percentage points to 4.0 per cent effective September 2021 absorbing a large portion of rupee liquidity from the banking system.
Several other regulatory measures were also implemented including the relaxation and subsequent removal of maximum interest rates on selected lending products, i.e., credit cards, pre-arranged temporary overdrafts, and pawning facilities.
Supported by these measures, market interest rates are expected to increase notably thus discouraging excessive consumption and encouraging savings. This will eventually help to contain aggregate demand in the economy.
Moreover, the CBSL engages with the public on the disinflationary strategy which will help bring down inflation in the period ahead. This communication and CBSL’s commitment to expeditiously bring inflation back to the targeted level would help to negate adverse inflation expectations.
Hence, it is expected that the build-up of demand-driven inflationary pressures in the economy will dissipate in the period ahead and inflation and inflation expectations will stabilise at desired levels.
Global price pressures are also expected to ease in the period ahead.

Has the CBSL reduced the printing of money?

Money printing is the process of supplying fresh money to the economy by the Central Bank. Money printing could be described in multiple ways as follows.

- An increase in the currency in circulation
­­- An increase in money supply or an expansion in monetary aggregates
­- CBSL purchases of government securities from the primary market (i.e., monetary financing)
­- Increase in excess liquidity in the domestic money market

The commonly referred definition of money printing is the CBSL purchases of government securities from the primary market, which in turn increases the CBSL’s holdings of government securities.
Money printing has been necessary to meet essential government spending (including salaries and wages), in the absence of sufficient government revenue amidst the COVID-19 pandemic and related disruptions to economic activity and current adverse macroeconomic conditions.
However, several measures were taken by the CBSL to curb the amount of money printed on a regular basis. Firstly, yields on government securities were allowed to increase to reflect market conditions, which helped the Government raise a larger portion of the required finances through market sources. Secondly, the CBSL provided the required financing only to meet the highly essential government spending. Accordingly, the increase in the CBSL’s holdings of government securities eased to a greater extent recently. Further, with the expected improvement in government revenue supported by the anticipated fiscal consolidation efforts, a noticeable decline in the CBSL’s holding of government securities is envisaged in the period ahead, thus reducing the extent of money printing.

Will the interest rates further increase or is there a possibility for rates to decrease?

In response to tight monetary policy measures of the CBSL, market interest rates have increased thus far in 2022 from the levels observed at mid-2021/end 2021.
These measures, particularly by way of tightening the cost (interest rates) and availability of credit, are to control inflation from the demand side.
If the adopted measures are insufficient to contain the demand-driven inflationary pressures in the economy, the CBSL would consider the necessity of raising interest rates further or any other measures that would contain excess demand pressures. However, if signs of stabilisation of inflationary pressures (following the implementation of tight monetary policy measures) begin to appear, the CBSL could gradually ease monetary policy by way of reducing policy interest rates in the future. As a result, market interest rates would decline.
Monetary policy decisions, mainly the decision on the interest rate, are in general data-driven and proactive. The Monetary Board makes decisions based on the developments on the global and domestic macroeconomic fronts, projections of key macroeconomic variables and emerging risks among others. Thus, the future course of monetary policy action would largely depend on these factors and the Monetary Board would take appropriate policy decisions to restore price stability.

 

Assistance from International Monetary Fund

How can IMF help Sri Lanka to overcome the crisis?

Considering the low level of international reserves, servicing the significantly high external debt service payments due in the near term became extremely challenging. Liquidity in the domestic foreign exchange market dried up amidst high import payments and the reduction in foreign exchange inflows, including credit lines for commercial banks. This caused a large deficit in the domestic foreign exchange market and a significant depletion of gross official reserves. Consequently, the country needed to secure some foreign exchange to meet the forex demands for essential imports, such as fuel, gas, coal, medicine, and essential food items.
In this context, there is a need for securing a sizeable amount of foreign financing in the immediate future. Entering into an IMF programme would not only provide access to additional financing but would also enhance the confidence of potential foreign investors, including multilateral and bilateral counterparts.
This, coupled with the implementation of a macroeconomic policy package, is expected to stabilise the overall macroeconomy which will further promote non debt creating foreign exchange inflows.
Further, IMF supported macroeconomic stabilisation program would help to gradually improve sovereign ratings and thus access to international markets for foreign financing would be made possible in the period ahead.

How will the IMF bailout work?

Objectives, policies and conditionality under an IMF funding arrangement depend on a country’s specific economic circumstances.
An IMF programme is designed in such a way that disbursements of funds are conditional on meeting Quantitative Performance Criteria (QPC), Indicative Targets (IT), Structural Benchmarks (SB) etc.
The IMF periodically reviews the performance of its programmes. To improve the programme’s success and reduce risks, the IMF recommends measures to improve the practicality of projections, sharpen debt |sustainability analysis, enhance the quality of fiscal consolidation, and improve the tailoring of structural conditions.

For further details refer the Box Article on ‘The Importance of International Monetary Fund Programmes’, Central bank Annual Report 2021,

https://www.cbsl.gov.lk/en/publications/economic-and-financial-reports/annual-reports/annual-report-2021

 

Debt Restructuring Process of the Government

What is Government Debt?

A country’s government debt is the total outstanding financial liabilities of the government arising from past borrowings. When a country is experiencing a fiscal deficit due to government revenue not being sufficient to meet government expenditure, the deficit has to be financed via borrowing from domestic and foreign sources resulting in accumulation of government debt. Government debt is a stock rather than a flow and hence, it is measured as of a given date. The government debt may be owed to residents of the country or to non-residents. The debt owed to residents are considered as domestic debt while debt owed to non-residents are considered as foreign debt. Debt can be denominated in local currency or in foreign currency and the domestic currency value of foreign currency denominated debt is sensitive to exchange rate movements. As at end 2021, the outstanding Central Government debt in Sri Lanka amounted to Rs. 17,589.3 billion, of which 63.1 per cent was domestic debt and remainder was the foreign debt.

What is Debt Restructuring?

When a country is facing difficulties in servicing its existing debt obligations or unable to refinance its existing debt, the Government may negotiate with the existing lenders to exchange the outstanding debt instruments such as loans and bonds to new instruments which have different debt service payments terms through a formal process to make the debt service payments more manageable. This is called debt restructuring. With the debt restructuring process it is expected that the Government will be able to service its debts under newly agreed debt service payment terms. Debt restructuring can encompass one or both of following components: debt rescheduling that involves lengthening the maturities of the old debt, probably under low interest rates; and debt reduction that involves reduction in face value of old debt instruments. Both components result in a loss to the lenders in present value terms.

How do you reduce/restructure debt?

Initially, it is necessary to undertake a comprehensive estimation of the total liabilities of the government and to whom the government owes. The Government needs to negotiate with the existing creditors to exchange the current debt instruments with new debt instruments that contain new debt service payment terms and conditions. The negotiations can be about reducing the interest rates, extending maturities of the debt instruments, reducing the face value of the debt instruments, and obtaining a grace or a relief period for debt service payments.  The revised terms of debt help improve the capability of the government in settling debt obligations in future. During this negotiation process, the government will have to provide an economic plan on improving and supervising the macroeconomic performance of the country, including the fiscal sector. Success of debt restructuring process may hinge on the involvement of a credible anchor such as IMF who may guarantee the country’s economic data, government’s economic plan as well as macroeconomic and fiscal supervision. When the debt restructuring terms are offered to lenders, acceptance or rejection of restructuring offer occurs at the discretion of the lenders.  Debt restructuring typically requires the consent of holders of some minimum fraction of the total outstanding debt. Hence during the restructuring process, lender coordination problems and holdout risks (i.e., considerable fraction of the lenders withhold giving their consent for the restructuring and retain their legal right to demand the full face value of the debt) remain acute concerns. Therefore, negotiations with creditor groups such as Paris Club, whose objective is to bring a workable solution to payment difficulties faced by debtor countries, will aid in expediting the debt restructuring process as well as in minimising lender coordination and holdout problems.

 

Economic Growth Prospects

What are the reforms required over the medium term to long term?

Over the medium to long term, the Government should establish a credible macroeconomic plan and a national policy agenda inclusive of reforms targeted at expanding productive capacity of the economy, while ensuring a high and sustainable growth path, which delivers equitable benefits for the entire nation with the collaboration of the all the stakeholders of the economy, in particular, the private sector. As reiterated by the ongoing economic crisis, long lasting structural impediments are to be resolved urgently in view of strengthening resilience of the economy against any kind of unforeseen shocks.
It is observed and the root cause of many of the prevailing macroeconomic imbalances is of fiscal origin. Thus, strengthening revenue mobilisation of the government and rationalisation of expenditure in a sustainable manner, enabling surpluses in the primary balance in the medium to long term are key reforms in ensuring fiscal sustainability.
Re-strategizing businesses of state owned enterprises, thereby preventing the financial burden of these entities on the Government as well as on the domestic financial sector. In this regard, other than the introduction of cost reflective pricing structures, institutionalisation of good governance and accountability mechanisms, notable productivity enhancements as well as service delivery enhancements in sector are required
Revamp social safety schemes of the government with better targeting of needy sectors and groups.
Strengthen the legal frameworks to ensure public accountability and transparency of state institutions.
Adopt a comprehensive and coherent approach in achieving and maintaining public debt sustainability.
Explore alternative sources of financing and implementing long due structural reforms enabling improvements to the financial strength of the banking system, to reduce the overreliance of the public sector on the banking system, including the Central Bank.
Strengthen foreign exchange inflows, in terms of non debt creating foreign exchange inflows, in particularly Foreign Direct Investment, to tackle the BOP issues on a sustainable basis.
Promoting domestic industries as import substitution industries, while diversifying export portfolio to non-traditional sectors and non-conventional destinations as well.
Implementation of a holistic energy plan, while focusing more on renewable sources aimed at ensuring energy security of the economy.
Promote sustainable finance practices in Sri Lanka that will be instrumental in routing credit towards environmentally friendly businesses.
Promote domestic production of fertiliser, agrochemicals as well as seeds.
Capitalise on the availability of a skilled labour force and the state-of-the-art IT infrastructure.

 

What can the CBSL do to help increase exports earnings to help build up foreign exchange reserves?

The Central Bank does not have a direct role in increasing exports. But by maintaining the stability in the economy and the financial system, and by engaging with government agencies that are directly responsible for export promotion at policy level, the Central Bank aims to create a conducive business environment for exporters to thrive.
The Central Bank aims to maintain a competitive exchange rate that ensures the international competitiveness of tradable goods and services.
Further, the Central Bank, in its policy advisory role, consistently highlights the need to increase the local value addition to meet rules of origin criteria necessary to benefit from free trade agreements and GSP schemes, the lack of growth in exports and the widening trade deficit and provide necessary recommendations to the government
By contributing to maintain a stable financial system and an advanced payments and settlements system, exporters can conveniently ship their goods and make and receive payments conveniently. The Central Bank actions to curb illegal and informal payment channels in the country helps to create a more robust, stable and reliable payment system for international trade.
The Central Bank compiles trade data and disseminates them to the stakeholders to enable them to make informed decisions related to external trade.
The Central Bank has also taken a leading role in presidential task forces that were established to monitor the progress of leading services and merchandise export sectors.
Also, the Central Bank is invited to participate in the trade negotiations related to bilateral and multilateral trade agreements where policy advise is provided.