Road Map 2018 and the "Impossible Trio"
The Road Map of the Central Bank of Sri Lanka for the year 2018 was presented on Wednesday by the Governor, Dr. Indrajit Coomaraswamy. It was presented after passing through a challenging year 2017. Even though it looks challenging for 2018 too, the Road Map shows the Central Bank’s monetary policy directions with promising prospects.
According to the Road Map, the Central Bank aims at maintaining price stability using its market-based policy instruments, supported by the government’s commitment to fiscal discipline. The Central Bank will also allow for a more flexible exchange rate determined by the market conditions which implies a more realistic exchange rate than what it was in the past.
On the basis of the above, I thought of showing a glimpse of the challenges we are faced with in 2018 and beyond. The issue that we take up today - the first week of 2018, is little heavy and complicated. Nevertheless, it is worthwhile comprehending it because it is in the heart of our economy from kitchen to mega business and, the nation’s progress and prosperity.
Challenges in the last year
The inflationary pressure was mounting in 2017 in response to swelling aggregate demand and unfavourable weather conditions. On a year- on- year basis, the rate of inflation was seen reaching 8.8 per cent by October 2017 compared to 5 per cent in October 2016.
Tightened monetary policy stance of the Central Bank appeared keeping the interest rates high, while the long term lending rates were over 15 per cent by the end of the year. The exchange rate was also seen depreciating, and reaching its average Rs/ US$ 155 by the end of the year.
Above all that, the economy showed dismal performance with slowing down growth of GDP. As per released national accounts data, the rate of real GDP growth was only 3.7 per cent during the period of first nine months from January - September 2017, compared to 4 per cent during the same period in 2016.
The outlook for the year 2018, thus, does not seem to be glowing at the beginning of the year.
Value of money
The core objective of Central Banking is maintaining the “value of money” which is termed as maintaining price stability and system stability. The first is, apparently meaningless without the latter because the system has to be stable in order to keep the price stability.
Basically maintaining the value of money means maintaining low inflation. According to the Road Map 2018, the Central Bank is aiming at 4 - 6 per cent inflation. There are different monetary policy approaches to maintaining low inflation, while one of them is called “inflation-targeting” which is the choice of the Central Bank of Sri Lanka.
Maintaining “low inflation” is not as easy as it appears to be, when there are multiple waves beyond the purview of the Central Bank, blowing and hurting its core objective.
The three core prices
There are three core prices: Commodity prices, interest rates and exchange rates. The value of money, depends on the movement of the commodity prices (inflation), measured in terms of the periodic change in the average price level of goods and services. Interest rate is the price of credit and, the exchange rate is the price of foreign currencies.
Maintaining the value of money cannot be looked at without focusing on the interest rate and the exchange rate as well.
Now we have a basic macroeconomic problem: All three core prices are interconnected so that the Central Bank is not in a position to ignore any of them. The task in the hands of the Central Bank then becomes even more complicated when there are policies and shocks beyond the purview of the Central Bank affecting all three price segments.
Ideal blend and the impossibility
All three prices should be flexible and stable, while the two features are not contradictory. Flexibility implies that they are responsive to demand and supply conditions in the respective markets so that the prices are realistic and competitive. Stability implies that they are not moving haphazardly so that the prices are fairly predictable lessening risks and uncertainty.
The problem is that we are not always sailing in calm waters as we have been throughout 2017. For instance, assume we have the same problem with all three prices as we had in 2017 so that ideally we want to contain them all simultaneously: 1. Then to reduce inflation, the Central Bank intervenes with tight monetary policy. This would ease the depreciating pressure on exchange rate too, but the interest rate would rise further. 2. To lower the interest rates, the Central Bank should come up with loose monetary policy. This would lead to exchange rate depreciation on the one hand and, increased inflationary pressure on the other hand. 3. To stabilise the exchange rate, the Central Bank should release its international reserves, hurting its flexibility. This would lessen the pressure on inflation rate, but interest rates would rise further. The three simple cases clearly show that, when the economy is hit by problems of all three prices, you cannot hold all of them together.
Is there a way out?
There is. It is a collaborative approach between the Central Bank and the government. In fact it is the most appropriate approach on a long-term basis. In this respect, the government has a critical responsibility and accountability in the following two areas: 1. The first is to aim at fiscal discipline through rationalising revenue and reducing expenditure - especially unproductive and wasteful expenditure. With a large political structure, an inefficient public sector, a set of loss-making public enterprises, and an increasing pressure on salaries and wages, apparently this requires a major reform process. The resulting lower aggregate demand, however, would ease pressure on all three prices - inflation rate, interest rate and exchange rate and allow the Central Bank to focus on its core objective. 2. The second is to aim at correcting the balance of payments problem through rapid export expansion. Because export growth is basically driven by private investment including FDI, the government has a facilitating role to play. However, this also requires fundamental reforms in policies, regulatory mechanisms, public administration and, public enterprises. Export growth would ease pressure on both exchange rate and interest rate on a longterm basis so that the task of the Central Bank would be easier. As the government is not yet ready with fundamental reforms as such, apparently the complexity and the severity of the task of the Central Bank is outstanding. But the Central Bank is not in a position to hold all three prices simultaneously.
By the way…
According to the Budget Speech 2018, Sri Lanka is also approaching a high debt repaying period from 2018 onwards. It is the Central Bank that has to manage public debt. Public debt repayment includes both domestic debt and foreign debt, which would entail increased pressure on both government expenditure and balance of payments. Therefore, fiscal consolidation and export expansion are not options and, neither are they alternatives. (The writer of this weekly column in the Business Times dealing with economic issues is Professor of Economics at the Colombo University)