Currency board vs fixed peg: Sri Lanka’s central bank defends discretionary monetary policy

Further details of the evolution of exchange rate regimes in Sri Lanka and the Central Bank’s current view on exchange rate management can be found in the following articles: 1. Weerasinghe, Nandalal, “Olcott Oration 2017 – Evolution of Monetary and Exchange Rate Policy in Sri Lanka and the Way Forward”4 2. Gunaratne, Swarna, “Determining the Exchange Rate – Exchange Rate Regimes in Sri Lanka”, 60th Anniversary Commemorative Volume of the Central Bank of Sri Lanka: 1950-2010, 2011. 3. Central Bank of Sri Lanka, “Exchange Rate and Economic Impact of Depreciation”, December 2016.5 https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/OlcottOrationEvolutionofMonetaryandExchangeRatePolicyandtheWayForward.pdf https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/otherpub/Information_Series_Note_20161203_Exchange_Rate_and_Economic_Impact_of_Depreciation_e.pdf In the modern world, only a few countries practice exchange rate targeting as the monetary policy framework as it requires a sizable international reserve to support the credibility of the regime. Exchange rate targeting is defined as the process through which a Central Bank intervenes in the market so as to maintain the exchange rate at a desired level or a pre-determined target. Singapore presents itself as a success story with the exchange rate being used as its key monetary policy instrument in its monetary policy conduct. As an economy that is heavily reliant on external trade and finance, with both imports and exports far exceeding the country’s GDP, the exchange rate has historically played a pivotal role in determining inflation in Singapore. Moreover, as Singapore operates a managed floating exchange rate regime, it has greater control over the exchange rate, particularly in the form of direct interventions in the domestic foreign exchange market. The exchange rate is allowed to fluctuate within a policy band, thereby allowing for it to act as a cushion against short term volatilities arising from imperfections in the real economy. Under this exchange rate based monetary policy framework, Singapore can ensure exchange rate stability while allowing for greater capital mobility, but has no control over domestic interest rates and money supply. While alleviating the impact of short term macroeconomic pressures, the exchange rate based monetary policy framework has also ensured that the exchange rate remains aligned with Singapore’s macroeconomic fundamentals. 9      c. From Monetary Targeting to Flexible Inflation Targeting Furthermore, greater fiscal discipline, flexible factor markets, robust financial system as well as innovation, have supported and led to the success of Singapore’s exchange rate based monetary policy framework. However, such an exchange rate based monetary policy framework may not be suited for a country like Sri Lanka as the country is experiencing persistent current account deficits and fiscal deficits with relatively large debt service payment requirements. Also, channeling efforts to maintain the exchange rate at a particular level would be at the expense of the country’s limited foreign exchange reserves. Moreover, the success of such a framework would require strong macroeconomic fundamentals such as fiscal surpluses, robust product, factor and financial markets, as well as greater policy stability and consistency. With the abandonment of the fixed exchange rate regime that was followed by Sri Lanka until 1977, interest rates and monetary aggregates, which had played a secondary role in Sri Lanka’s monetary policy framework until then, assumed a greater role. In early 1980s, Sri Lanka introduced a monetary aggregate targeting framework of monetary policy. This involved the use of policy instruments of the Central Bank to manoeuvre the operating target of reserve money (base money / high powered money) and the intermediate target of broad money in order to achieve the objectives of monetary policy. The annual monetary programme required under this framework is explained in the Annual Report of the Central Bank of Sri Lanka in 1982 as follows: “Having taken into consideration the real growth, estimated rate of price increase and increased monetisation of the economy, the desired monetary targets were set with a view to maintaining the consistency between financial and real output flows in the economy. The monetary targets were then translated into a permissible level of credit to the private sector by commercial banks after allowing for the impact of the behaviour of the external sector and the credit requirements of the Government.” Although inflation spiked at times during some periods under the monetary targeting framework with managed floating or free floating exchange rates, following strict monetary targets at times enabled the Central Bank to bring back inflation to tolerable levels in general. For instance, the implementation of strict quarterly reserve money targets when inflation peaked 10 at levels over 28 per cent in 2008, enabled a rapid disinflation during a short period of time. At the same time, the requirements for the successful implementation of monetary aggregate targeting, namely a close relationship between nominal GDP growth and broad money growth and a close relationship between money growth and inflation, were visible until around 2009. However, the gap between nominal GDP growth and broad money growth has widened notably since 2009. Even at times of high money and credit growth, inflation has remained in single digit levels. The ability of the Central Bank to contain inflation in single digits for a continued period of over 120 months, i.e., 10 years, in spite of relatively high average money and credit growth can be partly attributed to technological innovations which have changed the behaviour of the general public. However, it is likely that the efforts of the Central Bank to anchor inflation expectations around mid-single digit levels through active communication and commitment to maintaining inflation at such levels have contributed significantly towards this achievement. As the eventual breakdown of the relationship between monetary aggregates, inflation and GDP growth [See Figure 03] was anticipated in line with developments in several other advanced and emerging market economies, by late 1990s and the beginning of 2000s, the Central Bank had commenced an internal process to upgrade the monetary policy formulation and implementation process while strengthening research on alternative monetary policy frameworks. In addition to moving to a floating exchange rate regime and streamlining the objectives of the Central Bank, the upgrades included the introduction of the Monetary Policy Committee (which is a technical committee that makes monetary policy recommendations to the Monetary Board), strengthening the independence of the Central Bank by expanding the membership of the Monetary Board, commencing active open market operations and a policy rate corridor approach, signaling the changes in the monetary policy stance based on policy interest rates, announcing the monetary policy stance through a regular press release based on an advance release calendar, enunciating broad policies of the Central Bank for the medium term through an annual Road Map announcement, establishing a Monetary Policy Consultative Committee to obtain views of the private sector and academia, commencing an inflation expectations survey, encouraging the Department of Census and Statistics to update the inflation index and publish core inflation and continued strengthening of modelling and forecasting capabilities of technical staff of the Central Bank. Figure 03:

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