Evolution of Monetary and Exchange Rate Policy in Sri Lanka and the Way Forward

Nice speech by  Dr P Nandalal Weerasinghe, Senior Deputy Governor of the Central Bank of Sri Lanka. It discusses the history and evolution of monetary policy in Sri Lanka. Their central bank came up in 1950, 15 years after RBI:

Sri Lanka’s monetary policy framework has also evolved from a currency board arrangement before the establishment of the Central Bank of Sri Lanka in 1950. This history has been well covered in the masterpiece, “From dependent currency to central banking in Ceylon” written by Professor H A de S Gunasekera, in whose honour my retired senior central bank colleague Sirimevan Colombage delivered an eloquent speech recently at the University of Peradeniya.

From 1950 to 1977 Sri Lanka’s monetary policy framework was largely based on maintaining a fixed exchange rate regime in terms of fixing the value of Sri Lanka rupee first to the sterling pound and then to the US dollar. Under this fixed exchange  rate regime, domestic inflation was directly linked to foreign inflation and therefore there was no need for an explicit monetary anchor to manage inflation. The Central Bank did not have much leeway to control domestic inflation as the fixed exchange rate was the anchor to manage inflation. Like many other things, inflation was also more or less imported from the United Kingdom those days!

From 1977 onwards, they had managed float.

In November 1977, Sri Lanka embarked on a major economic liberalisation move, marking paradigm shift from inward looking restrictive policies towards a liberal regime under which trade and payments were liberalised to a great extent. To be consistent with the new liberal regime , the Central Bank abandoned the fixed exchange rate regime and moved to a more market based system of exchange rate management. On 15th November 1977, the prevailing dual exchange rates were unified at an initial rate of Rs. 16 against the US dollar. This was an overnight devaluation of the basic exchange rate by 120 per cent! The rupee was then allowed to float under a managed exchange rate regime. Accordingly, compared to the end 1976 exchange rate of Rs. 8.83 per US dollar, the exchange rate was recorded at Rs. 15.56 at end 1977.

This sharp devaluation addressed the overvaluation of the rupee observed under the fixed regime. The subsequent managed exchange rate regime allowed some flexibility to determine the value of currency largely on the basis of market demand and supply, while attempting to prevent the overvaluation of the rupee by maintaining the real value of the rupee against movements of a basket of major currencies. 

Hmm. It took much longer for India to move to managed floating exchange rate in 1991.

However, this moved led to more problems, leading to introduction of monetary targets:

The introduction of the managed floating exchange rate was a welcome move from the perspective of a liberal macroeconomist. However, this resulted in new challenges to the conduct of monetary policy, particularly as the exchange rate wasno longer available to anchor inflation expectations like in the past. The Central Bank also had to face a new challenge, as the government started to run extremely large fiscal deficits funded mainly by concessional external funding to develop public infrastructure such as the accelerated Mahaweli scheme

In 1982 they introduced monetary targeting:

The relationship between monetary expansion in terms of the amount of money held by the public and inflation has been well recognised in Sri Lanka from the beginning of central banking in the country. However, the first mentioning of “desired monetary targets” in a Central Bank annual report in Sri Lanka could be found in 1982. The 1982 annual report states that “the National Credit Plan for 1982 was formulated against the perspective of the prevailing monetary and credit policies. It attempted to rationalise the use of private sector credit among different sectors of the economy as an instrument of selective credit policy. Having taken into consideration the real growth, estimated rate of price increase and increased monetisation of the economy, the desired monetary targets were set in the Plan 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.”

Hmm.. He goes on to explain how the corridor system was introduced in 1990s.

Since Feb-2009, the central bank has managed to keep inflation in single digits which is an achievement given it has been in double digits previously. The average inflation in 2010-16 is 5.1%.

Now they are transitioning to an inflation targeting framework.

Considering the success of flexible inflation targeting in advanced and emerging markets, the Central Bank of Sri Lanka also considered this as the best framework to be adopted in the medium-term. A number of prerequisites for the new framework  have already been fulfilled by the Central Bank and the government during the past few years with the view of moving towards flexible inflation targeting in the medium-term.

At present, as an interim arrangement, the Central Bank conducts its monetary policy within an enhanced framework with features of both monetary aggregate targeting and flexible inflation targeting frameworks. Under this enhanced monetary policy framework, the Central Bank focuses on stabilising inflation in mid-single digits over the medium-term, while supporting the growth objectives and flexibility in exchange rate management. Although the Central Bank does not announce any monetary targets explicitly, broad money aggregates remain a key indicative intermediate variable to guide the conduct of monetary policy. Moreover, instead of  reserve money, the Central Bank currently uses the average weighted call money rate (AWCMR) as its operating target and increasingly relies on its market based policy instruments, namely policy interest rates and OMO.

Nice bit..

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One Response to “Evolution of Monetary and Exchange Rate Policy in Sri Lanka and the Way Forward”

  1. Bernard Rendler Says:

    Regards,

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