Sri Lanka’s economy faced heightened challenges in 2018 emanating mainly from the global economic, financial and geo-political developments that adversely affected the external sector, but with the cautious approach followed through monetary policy direction, the country achieved 3% economic growth.
However, it was below the predicted level, said Governor, Central Bank of Sri Lanka, Dr. Indrajit Coomaraswamy, presenting the Road Map which articulates the broad direction of monetary and financial sector policies for 2019 and beyond, in Colombo last week.
There were also several domestic challenges such as political uncertainties, especially during the last quarter of the year, which amplified challenges to overall macroeconomic stability. Sub-par economic growth continued last year following subdued growth in 2017.
Favourable weather supported a rebound in the Agriculture sector while the expansion in Services activities has been broadbased, he said.
However, industrial activities slowed in 2018 mainly due to the slowdown in the Construction sector. Consumer price inflation remained low in 2018 in spite of the temporary ups and downs due to volatile food prices and administrative price adjustments.
In response to the tight monetary policy stance pursued by the Central Bank in the past two years, monetary and credit growth decelerated in 2018 from the higher levels observed in 2016 and 2017. An adequate expansion in domestic credit flows driven by demand from the private sector was witnessed during the year.
“Being guided by these developments as well as considering impending risks and challenges, we followed a cautious approach in relation to the monetary policy conduct in 2018.”
Taking into account the favourable developments in inflation and inflation outlook, as well as the subdued performance in the real economy, the Central Bank signalled the end of Monetary policy tightening that commenced at end 2015, by reducing the upper bound of the policy Interest rates corridor in April 2018.
Nevertheless, considering the impact of global developments that affected external sector stability of the economy, the Central Bank maintained a neutral Monetary policy stance in the ensuing period.
The sustained high deficits of rupee liquidity in the domestic money market compelled the Central Bank to reduce the Statutory Reserve Ratio (SRR) applicable on all rupee deposits of commercial banks in November 2018, while increasing policy interest rates to neutralise the impact on interest rates due to the permanent liquidity injection arising from the reduction in SRR.
We followed this cautious approach with the broad aim of stabilising inflation at mid single digit levels and anchoring inflation expectations to enable the economy to reach its potential in the medium term.
In the external sector, the growth in export earnings was outpaced by the expansion in import expenditure, although earnings from tourism, workers’ remittances, foreign direct investment (FDI) and debt related inflows to the government helped cushion the balance of payments (BOP) to some extent.
The BOP experienced significant pressure on account of foreign exchange outflows caused by tightening global financial conditions and the strengthening of the US dollar in view of monetary policy normalisation, particularly in the United States, as well as the widened trade deficit. Similar to the pressure that was observed in other emerging market economies, these developments resulted in a sharp depreciation of the Sri Lankan rupee particularly during the second half of the year.
The Central Bank intervened in the domestic foreign exchange market at times to prevent disorderly adjustments in the exchange rate, while allowing demand and supply forces of the forex market to determine its level and direction.
The government and the Central Bank introduced several short-term measures to address the pressure in the external sector, although the external sector developments again highlighted the need for structural reforms to boost the tradable sector, particularly by enhancing merchandise and services exports in the medium to long run.
The external sector was also affected by political instability during the latter part of 2018. Political developments, compounded by concerns regarding fiscal slippage in the lead up to the elections, were significant causal factors in the decisions of all three major rating agencies to downgrade Sri Lanka’s sovereign ratings. This, in turn, negatively affected investor confidence.
However, such downgrading only on the premise of heightened political uncertainty and anticipated rather than actual fiscal slippage cannot be justified as there was no solid evidence of a deterioration in macroeconomic policies or fundamentals.
This was evidenced by the good progress in completing the fifth review of the Extended Fund Facility (EFF) of the International Monetary Fund (IMF) until October 26, 2018. Sri Lanka continued to receive the assistance under the EFF and we received the fifth tranche of the program in June 2018. We look forward to the successful completion of the IMF, EFF program in 2019. We are optimistic that the staff level agreement reached on principle with the IMF on the fifth review will proceed to the next level.
Although the government continued its efforts towards fiscal consolidation, the performance on the fiscal front was rather mixed in 2018. Lower than expected revenue collection is likely to challenge the achievement of the targeted budget deficit for 2018. However, the primary balance is expected to record a surplus for the second consecutive year in 2018.
This would be only the third time since 1955. Continued fiscal consolidation remains essential to build on the achievements already realised in the fiscal sector and to support the conduct of monetary and exchange rate policies without any fiscal forbearance.
As announced in last year’s Road Map, the Central Bank is progressing towards implementing flexible inflation targeting (FIT) as its new monetary policy framework by 2020. We have taken several policy initiatives to facilitate the transition to FIT during 2018.
While maintaining appropriate policy coordination with the government, we initiated the drafting of legal amendments to strengthen the mandate of the Central Bank to maintain low inflation, while strengthening its autonomy, transparency and accountability.
“During 2018, we also implement ed several policy measures to maintain a stable financial system with subdued macroprudential concerns, while increasing the resilience of the financial system to global and domestic shocks”.
To strengthen the legal and regulatory framework of the financial institutions, a new Banking Act is being drafted, while also initiating amendments to other legislation related to the financial sector.
“Resolution actions for distressed companies were taken in the form of imposing stringent regulatory actions such as restriction on business as well as suspension and cancellation of licences”.
“Consolidation will be encouraged in the banking and non-bank sectors through steady increase in capital requirements. Priority will be attached to achieving sustainable structures in both the banking and non bank sectors in an orderly manner. It is our intention to send the clearest possible signal that there will be no regulatory forbearance,” he said.
“We also continued to take measures to strengthen the payment and settlement infrastructure in line with our statutory responsibility of developing an efficient and stable national payment and settlement system capable of catering to the country’s growing payment needs,” the Governor said.
To promote digital payment mechanisms in the country, a national standard for QR code based payments was introduced during 2018, while progress was made in setting up the National Card Scheme.
The Central Bank also continued to perform its currency management function to facilitate smooth transactions in the economy, while taking measures to preserve the quality of currency notes in circulation.
Priority was also attached to strengthen the Central Bank’s agency functions in 2018. Public debt management was carried out in a way that the government’s financing requirements were met at the lowest possible cost with a prudent degree of risk, while aiming to maintain debt sustainability.
There was continued focus on sustaining the transparency and efficiency of the auction system for Government securities as well as on developing a viable medium term debt management strategy. In consultation with the government, we also initiated actions to implement liability management exercises on future debt obligations, based on the newly enacted Active Liability Management Act (ALMA).
The liberalisation of foreign exchange transactions was advanced with the introduction of the Foreign Exchange Act No. 12 of 2017 (FEA). Procedures for inward capital flows were further simplified and streamlined for smooth transferring of funds for investment, while limits for outward capital flows were enhanced in selected areas giving local investors access to a wider global market.
As a facilitator, the Central Bank continued its development finance and regional development activities during 2018 with the broad aim of enhancing inclusive and balanced economic growth and financial inclusion in the country.
“Progress was made in formulating the National Financial Inclusion Strategy. Further, the Central Bank worked towards improving Sri Lanka’s global position with regard to the implementation of Anti-Money Laundering and Countering the Financing of Terrorism regulations, and we entered into new MoUs with several government bodies and institutions last year. We are working towards Sri Lanka being removed from the Financial Action Task Force’s (FATF) ‘grey list’ by mid 2019.
A number of measures had also been taken in the pursuit of greater accountability and transparency. In particular, following the recommendations of the Presidential Commission of Inquiry to Investigate, Inquire and Report on the Issuance of Treasury Bonds, measures are being taken to strengthen several laws applicable to the Central Bank.
Measures were also taken to reform the operations relating to the issuance of government securities, introduce a new investment policy framework for the EPF, strengthen internal audit and introduce the code of conduct for employees and the members of the Monetary Board.
The procurement process for several forensic audits is under way, and forensic audits are to be conducted by entities with global practice.
In a challenging global and domestic environment, the Central Bank is steadily improving its policy frameworks to mitigate possible risks and thereby achieve its broad objectives of economic and price stability and financial system stability.
Our action would be effective and yield the desired outcomes only if certain conditions are met, especially the commitment of the government to macroeconomic stability.
Given the prevailing low growth trajectory, growth promoting policies and structural reforms are much needed priorities for the government. This must, however, be done without disrupting the fiscal consolidation process.
“For this to happen, the enabling environment must be created for the private sector to play a more active role. We need consistent and predictable policies from the government and a more dynamic and entrepreneurial mindset from businesses.
The Government’s initiatives aimed at improving the economic and social infrastructure of the country, enhancing productivity, up-scaling skill levels of the labour force, as well as expanding domestic production capacity, are vital elements to support an accelerated and sustainable level of economic growth while maintaining a continued low inflation environment.
Timely implementation of consistent and coordinated policies in a coherent manner is also essential to ensure the realisation of the expected outcome of such policies. In this context, this Road Map sets the basis for strong policies and credible frameworks to achieve macroeconomic stability with the support of the government and private sector stakeholders.