Managing inflation, interest rates and exchange rates: the balancing act

by Ajith Nivard Cabraal

The Ceylon Chamber of Commerce (CCC) requested me to speak about “Managing inflation, interest rates and exchange rates: the Balancing Act”, at their Annual Sessions this year.

It is significant that the Ceylon Chamber of Commerce (CCC) realizes that this is a balancing act, and that these variables have to be balanced. This is a good opportunity to examine these issues closely. When we do so, we would probably see that there are several conflicting objectives that need to be balanced simultaneously, when managing an economy.

What are these Variables? Let’s initially discuss the variables that the CCC has requested us to concentrate upon. Thereafter, let’s examine the other major macro-economic fundamentals that are also imperative. There are hundreds of important variables, but we will, today, examine some of the key variables only.

No one likes inflation. Everyone likes low and stable prices, better standards of living, higher wages, incomes and profits, and a higher purchasing power and wider choices.

But, the globalized economy is continuously subject to demand and supply shocks, local and external. Therefore, it’s not easy to maintain stable price levels. It’s also not easy to compare inflation across countries because of different consumption patterns, methods of computation, expenditure bases, etc.

Inflation is simply defined as the continuous increase in the general price level. In the long-term, inflation is a monetary phenomenon.

Demand-driven inflation is caused by monetary expansion and the Central Bank has control over the demand-driven inflation. In the short-term, inflation is also affected by supply conditions. Supply-driven inflation has to be contained through increased production and productivity.

How has Sri Lanka fared with Inflation? Not too well. Our average inflation over the 30 years (1978-2007) has been 11.7%. In many other countries, it is well below this level. Today, the moving monthly average inflation is 21%. The world commodity and oil prices have soared, surpassing everyone’s imagination. Inflation in many countries has almost been doubled.

Monetary policy in 2007 and 2008 has been the tightest ever when compared with the policies over the past several decades. Tight reserve money targets have been announced and achieved.Interest rates have risen considerably as a result. Growth in credit has also slowed. Demand has thereby decelerated.

But, owing to supply shocks, both local and global, inflation has been persistently rising.

What does tight Monetary Policy do? For a start, it decelerates demand, and consequently moderates inflation. But, over time, due to the interest rate increase, business activities suffer. With the resulting credit decline and demand deceleration, growth decreases and other benefits that arise from growth, get affected.

That’s the adverse side-effect that arises when administering tight monetary policy to deal with the inflationary conditions. So, the objective should be to contain inflation without killing growth.

Background to interest rates

Interest is a consideration that is paid for the use of capital. Demand and supply of capital will determine the interest rates. Interest rates have to be kept high when inflation is rising in order to reduce liquidity and thereby curtail demand. By doing so, the tendency for price rises is curtailed.

Low interest generally spurs growth and credit expansion, while high interest tends to suppress growth tendencies. Therefore, interest rates have to be kept high only until inflation moderates. Thereafter, interest rates could be allowed to decline. Here again, we have to strike a balance with the conflicting variables judiciously.

The exchange rate is determined by the demand and supply of foreign currencies into the economy. Inflows take place as a result of (a) exports, (b) inward remittances, (c) capital flows and (d) loans. Outflows take place as a result of (a) imports, (b) loan repayments, (c) capital transfers and (d) interest payments. If inflows are higher than the outflows, the local currency would appreciate. If not, the local currency would depreciate.

The trade deficit and current account deficit has been generally dealt with a gradual or sometimes steep depreciation of the SL Rupee. For the last 50 years, Sri Lanka has been managing its economy on the basis that the Sri Lanka Rupee should depreciate its value vis-a-vis other currencies. Very little has been done to address this issue on a long term basis with a clear policy of improving productivity.

On average, the SL rupee depreciated by 5.9% during 2001-2004. In 2005, the SL rupee appreciated by 2.4 % due to tsunami inflows and the unsolicited debt moratorium. In 2006, the depreciation was 5.2% In 2007, depreciation was 0.9%, and so far during the first half of 2008, the rupee has appreciated by around 1.0 %

We have generally assumed that it is good to allow the exchange rate to depreciate in order to allow our exports to be competitive, and to discourage imports. Maybe, this happened. This was also a prescription of the IMF and WB for the Exchange Rate management. But, what else happened?

Out of our external public debt of Rs.1,295 billion as at 31st March 2008, Rs. 620 billion or 48% or nearly US$ 6 billion of external debt has arisen only due to the rupee depreciation. In fact, a huge additional debt burden has been “created” without a corresponding asset.

Depreciation factor

The artificial “creation” of debt as of now amounts to more than the entirety of last year’s government revenue.

It is also enough to: construct 15 Hambantota Ports, or construct 30 Southern Highways, or pay the entire Government salary and pension bill for two years or pay the salaries of the entire armed services for 10 years.

Instead of waiting for the exchange rate to depreciate and then for our businesses to become competitive, it is time for all of us to improve our productivity in whatever manner we can. Obviously, it is the time to revisit our exchange rate policy.

Many countries developed when their productivity levels improved. As a result, their currencies enjoyed an appreciation vis-a-vis their main trading partners. That was the tough path. Sri Lanka took the easy path of allowing the SL rupee to depreciate with the hope that exporters would benefit and hopefully, importers would get discouraged.

To what extent should we improve our Productivity? We must increase our productivity levels by at least 7-10 per cent per annum at all levels of management and activities for the next 5 years for the 1.2 million government and approximately 6.0 million private sector workforce. If we do so, we can comfortably maintain the exchange rate at the current levels and lessen the impact of imported inflation.

In which areas can we improve Productivity urgently? Increase our milk production from the present 200 million litres to 1 billion litres (75% of the country requirement) is one key area. Increase our sugar production from 55,000 metric tons to 350,000 metric tons (60% of the country requirement) is another.

If we produce these basic food items domestically, we can save at least US$ 250 million and help our exchange rate to maintain value. We have an EEZ 8 times larger than county’s land area. This is an area with enormous economic potential.

Every country has to record a reasonable economic growth as otherwise the economy would quickly stagnate. Growth should be country-wide and reach all sections of the population. Sri Lanka has had an average growth of 4.2% from 1950 - 2004, and the average growth for the past three years has been 6.9%. This has helped us now reach a per capita income of US$ 1,615.

Growth at any cost?

Growth, if too fast, can over-heat the economy, while growth, if too slow, can lead to stagnation and political unrest. So, growth also needs to be managed with the rest of the macro-economic variables.

At the same time, regional disparities need to be addressed and strategies for balanced regional development should be implemented.

That is why mega projects on a provincial basis, and village-based projects on a micro basis, have to be implemented simultaneously. It is imperative that we allow the growth momentum to continue, without interrupting it too severely.

Poverty has reduced from 22.8 per cent in 2002 to 15.2 per cent in 2007. Unemployment has reduced from about 12 per cent in 1995 to 5 per cent in 2007. However, there are still several districts where the poverty levels are unacceptably high.

When we think of maintaining the momentum of reducing poverty and unemployment, it is essential that poverty levels are reduced at a fast pace with perhaps a target of reducing the level to not more than 5% by the year 2015. Lower unemployment will help minimize disparities.

The realization of such an outcome needs more growth and investment. That is why growth and investment (both public and private) cannot be compromised too much, even in times of high inflation.

We have to be careful in raising the public debt stock, even though we have to depend on debt finance to cover the resource gap in the country.

That is why it is important to move towards private- public partnership. We have now removed many shackles. The private sector must now respond to this challenge and access the worldwide capital and debt markets so that they could participate in the large projects themselves.

Sound infrastructure is vital for high growth. Today, we have an unprecedented infrastructure development initiative that is being implemented. The work-in-progress on infrastructure development amounting to nearly US$ 5 billion is much more than at any time in the history of our country.

A sound infrastructure, serves to attract foreign and local investments - more than tax relief and other benefits. Sri Lanka has still a long way to go in bringing infrastructure up to the level of countries which enjoy per capita incomes of US$ 3,500 to 4,500.

This infrastructure development momentum has to be continued at the same pace or at a higher pace for at least the next 10 years, both at a national level and a village level. High interest discourages investment in infrastructure. That is why we are opening out access to capital from international markets to the private sector as well.

While balancing the other macro-economic variables, we have to maintain financial system stability too. That is the health of financial institutions, infrastructure, instruments, and products. Poor governance in banks and other financial institutions have led to collapses in other countries. We should learn from others’ mistakes and be very wary.

We also have to quickly improve corporate governance of financial institutions, and ensure that the general public has confidence in the financial system.

The fine balance in the economy can easily get disturbed if there is any national security issue, food security issue or a spate of industrial disputes. A country has to allocate sufficient resources for national security, so as to provide a safe environment.

Food security is a human issue, which is beyond cost and price. If there’s food insecurity, it will affect the overall social stability.

Industrial harmony actively supports economic activities.

In cricket, we cannot concentrate only on batting. We also have to capture wickets and take the catches. It is a balance. In the same way, all macro-economic fundamentals have to be balanced at the same time. We cannot focus only on one aspect while ignoring others.

Trying to infuse experiences of other countries, however successful, without reference to the local conditions, is sometimes detrimental. By all means, let’s understand the principles of success of other economies, analyze the logic of successful strategies. But, let’s implement in Sri Lanka, policies that would succeed in the Sri Lankan political, economic and social frameworks.

Balancing with many variables is not easy. The balancing act is made even more difficult, if while all these macro economic fundamentals are being managed and balanced, the platform itself is unstable.

Terrorism is posing tremendous challenges to Sri Lanka and the world.

There is an economic cost for the war against terror. But, what is the long-term solution? A country has to respond to terrorism both militarily and politically. Recent events show that such a response will yield long-term favourable returns. The liberation of the eastern province from the LTTE is a very good example.

Now, the entire world faces an unprecedented shock from the very high food prices. As a result, many developing countries are now facing very high inflation. The problem is not unique to Sri Lanka.

Worldwide Economic Turmoil is continuing with capital and debt markets still grappling with “sub-prime” and other credit qualifying issues. The US is struggling to avoid a recession. The slow down in the US economy has affected the growth in almost every country, including the emerging economies of China and India.

These unsettled economic conditions increase the risk and uncertainty faced by countries like Sri Lanka as well.

Some groups with vested interests misguide the general public and investors deliberately. They constantly publish lies, half-truths and biased analysis to discredit the country and economy, and diminish confidence. Some of the misinformation is carried out by politicians wearing economic cloaks!

Oil prices have increased almost 5 fold since 2003. Some analysts project that it will hit US$ 200 per barrel during the year. High oil prices severely challenges price stability, cost of industrial production as well as the health of the external sector. People making estimates based on oil prices, are having nightmares.

What is the Answer? Obviously there is no single right answer. There is also no right solution, that will deliver optimum values to each of these macro-economic fundamentals.

A policy initiative to deal with one variable could very well have adverse implications on another, even to the extent of negating the estimated benefit completely.

The challenge before us is to balance these many competing factors in a rational manner to deliver short-term successes and long-term optimum results. That certainly is a tough proposition...

It is easy for a person who is only dissecting or analysing one of the variables to find fault and offer good advice to deal with that aspect only. Often, they do not see the implications of such suggested actions on other variables. It is rare for such persons to see and understand the “big picture”.

Managing the economy in turbulent times is like managing a difficult patient with multiple ailments. Sometimes, administering a very good drug that is needed to manage a particular condition of the patient could have disastrous side-effects because of another ailment that the patient is suffering from.

A good physician would administer drugs for the different ailments with caution, care and concern, so as to manage the several ailments simultaneously, without harming the patient permanently, and, in that manner, lead him to good health and well-being.

Managing the economy in turbulent times is also like juggling on a shaky platform.

The trick is to keep all the balls in the air without dropping any. When the platform itself is shaky, it will be tough, but the goal is to keep going.

But we can have hope. It is not easy, but, it could be done.

The last two years have been unprecedented in its challenges. We have shown that it is possible to survive and grow even in these adverse circumstances, if we keep going and work on our strengths.

(Based on a presentation made by Governor of the Central Bank of Sri Lanka at the Ceylon Chamber of Commerce Annual Sessions)