US $ 500m through International Sovereign Bond, a major turning point:

Inflow of foreign funds vital for economic growth

By Shirajiv Sirimane

During the second half of 2007 when the country was fully engaged in the major humanitarian operation, while the global environment was becoming more and more unstable. The local environment was also tense, not withstanding all efforts. Inflation was high; interest rates were high; the exchange rate was under threat; and the fiscal deficit was expanding rapidly, because of the ever-increasing need for finances to fund the massive infrastructure development program and to meet the costs of the humanitarian operation.

To deal with this challenging situation, the Ministry of Finance (MoF) and the Central Bank (CB) decided that it was vital that a further sizeable injection of long term foreign funds was given to the economy. It was only such an infusion that would allow us to maintain stability, as well as be able to have the much needed funds to keep the infrastructure development effort going.

Some financially savvy members of the Opposition too, realised the significance of such a fund infusion into the economy, and tried their utmost to scuttle that effort. But, fortunately, we were able to defeat those endeavours, and raise the all important bond, and tide over the risky period.

The infusion of the new funds immediately brought stability to the economy and also acted as an important stimulus for growth, with the new additional resources quickly filtering down into the economy.

Hence, as a result of the move, the Fiscal framework was supported with the moderation of interest rates; the monetary framework was facilitated with the stabilisation of prices; and exchange rate was supported by the buttressing of international reserves.

I believe that, some day when’re Lanka’s economic history is being written, this 2007 infusion of US$ 500 million through the international sovereign bond, would be marked as a major “turning point” in our economic landscape, said Governor, Central Bank, Ajith Nivard Cabraal delivering 18th Annual Oration at the Institute of Chartered Accountants on the subject of “Harmonising Fiscal and Monetary Policies to Deliver Stability and Growth”.

“I also believe that the benefits of this landmark move has been of an enduring and permanent nature, as evidenced by the fact that, over the next 5 ½ years, the Government has been able to raise a further US$3 ½ billion from international bonds, with the coupon rates tightening considerably each year. Another benefit that this initiative entailed was that it paved the way for several banks and corporates to also issue international bonds, thereby accessing savings from outside the country. By doing that, we had also been able to bridge the chronic savings/investment gap that has been regularly referred to by a never ending stream of experts since independence, as a major deficiency that was hampering growth in our economy.”

The recent Evolution Economy let us initially examine a snap shot of our economy in 2005. Growth in 2005 was 6.2 percent,with the average growth for the 7 years,1999 to 2005,being 4.3 percent; Foreign reserves were around US$ 2.7 billion, or about the equivalent of 2 ½ months imports; The country was at the mercy of a ruthless terrorist group and on the brink of war; Unemployment was at 7.2 percent; Poverty was at a level over 15 percent; Inflation was on a sharp rising trend; The banking system was vulnerable and displaying several worrisome cracks; Public debt to GDP level exceeded 90 percent; Per capita income was under US$1,250; GDP was around US$24 billion; The Western Province share of GDP was an overwhelming 51 percent;Infrastructure development was almost non-existent; The fiscal deficit was over seven percent although very little infrastructure development work had been carried out. All in all, a rather bleak picture, and worse still, a bleak outlook.

Let us now see what it is like today: Growth is over seven percent, and average growth from 2006 to 2012 has been 6.7 percent; Growth appears to be on course to reach around the 8% level from next year; Foreign reserves exceed US$ 6.3 billion and around 4.4 months of imports; The country enjoys peaceful and stable conditions; Foreign investment inflows are strong and foreign investment via international sovereign bonds and Government paper amounts to about US$7.0 billion; Unemployment is around 3.6 percent; Poverty is down to around the 6 percent mark; Inflation has been at single digit levels over the past 4 ½ years; GDP is at about US$60 billion; Per capita income is around US$ 3,000;The economy is being diversified under a 5Hub + Tourism strategy to avoid the middle income trap;The Fiscal deficit has been limited to 6.4 percent in 2012, and on a reducing trend; The Debt to GDP level is below 80 percent and falling; The level of infrastructure has improved tremendously; The Doing Business global rank is at the 81st, and is poised to jump about 10 places this year; Regional development has made tangible progress and the Western Province share of GDP has dropped to around 43 percent; Regular foreign investment is flowing into banks and the stock market; Private remittances have reached nearly 10 percent of GDP, or about US$ 6 billion in actual inflows; The banking system has been stable and even in the midst of very difficult global circumstances, the country enjoys favourable reviews from many influential international quarters.

A dispassionate comparison of the conditions prevailing in 2006 and 2013 tells us that our economy has made an unprecedented transformation over the past seven years, with strong economic growth, and stable macro-economic conditions. Harmonisation of Monetary and Fiscal Policies One striking feature in the implementation of Monetary and Fiscal policy over the past 7 years, has been that both institutions, MoF and CB have been taking a keen and enduring interest in both monetary and fiscal policies. We realised that a “blame game” would be of no value to the country or to the stakeholders, and that it was absolutely vital that we should deliver on both fronts simultaneously.

Having said that, we will now discuss some case studies that would throw some light about the degree of harmonisation that took place between the policies of the Central Bank and the Ministry of Finance, in order to deliver some of the vital results to our country and economy, over the past seven years.

Case Study 1: Opening out Sri Lanka Treasury Bills and Bonds to foreign investors: The first case study that I would like to cite is the November 2006 move to open out Sri Lanka Treasury bills and bonds to foreign investors. By late 2006,in Sri Lanka, a massive infrastructure development program had been launched, and the critical humanitarian operation had begun.

These twin programs had demanded a regular, steady and massive flow of funds, and it was becoming increasingly clear that we would not be able to secure the new fund requirements only via local taxes and local borrowing. If such a quantum of funds were to be sourced from within, an enormous pressure would have been exerted upon the entire economy.

In fact, such an attempt would have pushed interest rates to unacceptable levels, and may have even dragged the economy towards negative territory, and placed the entire monetary system at considerable risk. Such fears may have perhaps been one of the reasons that prompted successive governments of the past, to avoid large scale infrastructure development programs or attempt to launch a full scale counter action program against terrorism.

However, the government of President Mahinda Rajapaksa took the bold decision to undertake both these missions, and the fiscal and monetary authorities had then to find innovative ways to support those missions, without placing the economy under undue risk or peril. As a response therefore, in late 2006, the Treasury and the Central Bank decided to open out a small portion of the Government Treasury bills and bonds to foreign investors. This was the first move to attract foreign investment into Government rupee paper, and it was naturally a fresh and exciting experience for both the Sri Lankan authorities as well as foreign investors. You may note that I said, “Foreign investment”, and not “foreign direct investment” or FDI. That is because, in our view, what was vital was that “foreign investment” should be allowed to flow through convenient instruments to supplement the shortfall in savings and investments in our country’s economic structure, and such inflows need not necessarily have been only via FDI.

The move resulted in new and quick inflows, and as a result, debt management became more dynamic and robust. It also provided a new tool to address the wide fluctuation of interest rates that was taking place in the country, prior to the move. One of the important lessons that we would take away from this case study is that the initiative was implemented as a result of the close harmonisation between the MoF and the Central Bank.

Had any one of the two agencies not fully supported this bold and imaginative move, the initiative would have failed, or worse still, been still-born.

Case Study 2: Debut International Sovereign Bond: The second case study that I would describe this evening is the debut international sovereign bond of Sri Lanka, in 2007.

Case Study 3: Intervention to stabilise a systemically important bank: The third case study that I would like to illustrate is the instance where the Central Bank and the Ministry of Finance teamed up to stabilise a systemically important bank that was facing a liquidity crisis in late 2008/early 2009.

Mr. Chairman, If we take our minds back to that period, in late 2008, we would recollect that the external environment, internationally and locally, had become even more hostile and highly uncertain.

Internationally, the global financial crisis had taken a major toll, with hundreds of banks collapsing across the world. Each day, we were hearing about the collapse or the imminent failure of many big names in the global financial landscape.

In many countries, the Ministers of Finance and the Governors of the Central Banks were huddled in endless discussions as to what should be done to arrest the crises, or how-to stop the bleeding. Businesses were going bankrupt by the thousands. Business confidence level was at rock bottom. People in all parts of the world were in panic. Locally, our humanitarian operation had entered a final and most critical stage, and enormous pressure was being exerted on the economy.

In that background, when a systemically important bank showed signs of a liquidity crisis, we knew that such an event, if allowed to escalate, could have dragged our economy to chaos, and our humanitarian operation to a standstill. We had to act decisively, and fast. We could not have delayed responding to this grave threat, or got it wrong.

Fortunately, the Central Bank was ready. We had already developed a bank intervention operation, code named Sigiriya , to deal with a situation of a liquidity crisis in a bank. The time had come to activate such a mission. But to do so, the first step was vital.

That was to apprise the Minister of Finance and obtain his approval to make the intervention.

If the Minister of Finance were to approve such an intervention, if would be the first time ever, in Sri Lanka, that such a rescue operation was attempted. At the same time, the experiences of other countries during that period, were not too encouraging. In many countries, including the UK, (as in the case of the Northern Rock Bank), the Finance Ministers and the Governors of the Central Banks had been in protracted discussions for many weeks about this type of intervention, without reaching agreement.

Fortunately for Sri Lanka however, such procrastination did not take place. The Minister of Finance was decisive, and after a single” one-on-one” discussion with me, he gave the approval for the Central Bank to proceed with implementation of the intervention plan. The rest is history.

The newly appointed directors and the managing agents, with the Central Bank in the background, were able to stabilise the bank within a short period of about two weeks. Thereafter, within a few months, the bank was able to infuse new capital and thereby qualify to exit from the close monitoring system of the Central Bank, in less than a year.

This episode will be an important lesson for those who wish to study the way Governments and Central Banks should cooperate to bring stability, in the face of any instability in the banking sector. It also confirmed the validity of an important annotation in Exter’s Report.

Case Study 4: The creation of our present day “virtuous cycle”: I would like to now place before you, yet another significant example of harmonisation between the Monetary and Fiscal policies, which led to the creation of a new “virtuous cycle” in relation to inflation, interest rates, investor confidence and sustained growth, in our country.

As we are all aware, Sri Lanka had been long trapped in a “vicious cycle” of high fiscal deficits leading to high inflation; high inflation leading to high interest rates; high interest rates leading to low investor confidence; low investor confidence leading to sluggish investment; sluggish investment leading to low growth; low growth leading to high debt; and high debt once again leading to high fiscal deficits.

This was the vicious cycle that we had been trapped, for more than five decades since independence. It is true that we have had one-off spurts of high growth or short periods of low inflation at various times in our history. However, we have to acknowledge that, other than in 2010 and 2011, we have never had over eight percent growth in consecutive years, or, for that matter, been even able to record an average growth of over five percent over a five year period, prior to 2006!

At the same time, other than the period February 2009, till now, Sri Lanka had never enjoyed a period of even two continuous years of single digit inflation, and, believe it or not, our level of average inflation was over 12 percent prior to that!

What was worse was that there was almost a sense of acceptance of such performance among many officials of both the MoF and CB, who harboured the internal view that it may be our country’s “karma” to have low growth, large fiscal deficits and high inflation!

In fact, many Central Bank officials were often heard to lament that the continuous high fiscal deficits of the Government was pushing inflation up and grumble that the Government will never stop doing that. In turn, of officials used to complain that the tight and in-sensitive monetary policies of the CB were the root cause for the fiscal deficit always being out of control!

It was therefore clear that a change in attitude and a change in action were vital. It was also necessary to make some effective interventions to change the equilibrium of this vicious cycle, so that a fresh equilibrium could be created. Towards that end, I remember, having several “one-on-one” discussions with the Secretary to the Treasury, Dr. P.B. Jayasundera in late 2006 and early 2007, to jointly decide on this all important priority.

Based on such discussions, we decided that we would take the necessary initiatives to improve investor confidence so as to ensure the continuous investment via the Government and the local private sector, whilst specifically targeting new foreign investment.

Accordingly, many initiatives were implemented, and over a comparatively short period of time, such efforts started showing results, and the country started to record a steady inflow of foreign investment through major government projects, investments in Treasury Bills and Bonds, and investments in international sovereign bonds.

This regular flow of investments enabled the economy to record sustained high growth, even whilst the conflict was raging. As a consequence, Sri Lanka recorded an average growth of 6.7 percent through 2006 to 2012, which was one of the most difficult periods in our history.

In fact, the growth levels of 2006: 7.7 percent, 2007: 6.8 percent, 2008: 6 percent, 2009: 3.5 percent, 2010: 8 percent, 2011: 8.2 percent, and 2012: 6.4 percent, were the highest ever in any seven year period in our history! That meant that our joint strategy had paid off, with sustained growth being recorded.

With such sustained growth and with the pipeline of continuous investments, the economy was gradually transformed to a more stable level, and with that, all other key factors in the vicious cycle also began to change for the better.

Initially, certain critics did not believe that we would be able to escape from the vicious cycle that had trapped the country for decades. They wrote to the newspapers and gave TV interviews stating that the initial successes were flukes and were not sustainable.

They warned that the economy would return to the vicious cycle once again. They continued to support their arguments with many high sounding theories and hair-splitting formulas, and Dr. Jayasundera and I were ridiculed, and often described as the villains responsible for the impending disaster. We were regularly featured in some unflattering, but nevertheless enjoyable cartoons as well!

But, today, those critics are finding it increasingly difficult to sustain their criticism, in the face of the gradually emerging new equilibrium of the” virtuous cycle” that our new harmonised policy framework had been able to generate. Presently, even though a minority stubbornly refuse to see what is unfolding before their very own eyes, this new cycle has taken shape: Low inflation leading to real interest rates; real interest rates leading to enhanced savings; enhanced savings leading to a regular pipeline of investment; regular investment leading to lower debt levels; lower debt levels leading to sustained growth; and sustained growth once again leading to low inflation.

What that tells us is that we have been able to break free from the previous vicious cycle, and have now placed the country on a more virtuous cycle! The challenge therefore would be to carefully nurture and guard this new equilibrium, knowing fully well that the disturbance in even one of those components could change that situation with adverse results.

Case Study 5: The establishment of the Deposit Insurance Scheme: Let me now illustrate yet another example of harmonisation. This is in relation to the establishment of the Deposit Insurance Fund and Scheme.

My colleagues at the Central Bank have told me that discussions in connection with the setting up of a Deposit Insurance Scheme had been taking place at various times, over the past two decades!

However, there was no consensus reached on a suitable mechanism, particularly because the large initial capital that was required for the establishment of such a scheme, could not be allocated by the Government for many years due to the intense pressure upon the need to allocate funds for other more pressing needs of the state.

Nevertheless, it was considered vital that such a fund and a scheme should be established, and hence an innovative method had to be structured, without placing an additional burden upon the Government coffers.

In 2010 too, internal discussions were once again taking place with regard to the possible setting up of a Deposit Insurance Fund. At that time, we noted that the abandoned properties of the banks, which constituted the dormant account balances of over 10 years, had risen to a sizeable amount, and according to the law, those funds had to be placed by the banks with the Government for safe keeping.

Accordingly, it was then decided by the MoF and the CB to use the funds so placed, as the nucleus of the Deposit Insurance Fund. Thereafter, the regular premia paid by the banks and finance companies, based on a pre-determined formula, could be credited to this new Fund, and thereby, build up the Fund.

In order to implement such plan, an arrangement had to be made with the Government, in that, instead of crediting the abandoned property funds to the fiscal coffers of the Government, such funds could be retained by the CB for the purpose of initiating the Deposit Insurance Fund.

In that manner, the new deposit insurance fund was created, and as a result, a long felt need was fulfilled! In fact, that scheme was innovatively designed not only to provide for a “pay out” in the event of a financial institution collapsing or being rendered dysfunctional, but also to provide funds for the purpose of reviving and/or restructuring viable financial institutions that face liquidity crisis from time to time. In that context, I am pleased to state that the Monetary Board has recently decided to invest a part of the fund to deal with some of the structural imbalances that have arisen in certain finance companies, so that such an infusion would encourage new investors to take over, revive and restructure such troubled institutions, with greater confidence and certainty.

Case Study 6: Stabilization measures of 2012 :The next illustration I want to present to you is one of the clearest examples of policy co-ordination between fiscal and monetary policy.

That was the stabilisation package of 2012, which was introduced by the MoF and the CB from February to April 2012, in response to the pressure on the balance of payments, high imports, high credit growth and pressure on the exchange rate.

As we all know, to deal with that growing tension, the Central Bank increased the policy interest rates, allowed the exchange rate to be more flexible and placed a 18 percent credit ceiling upon banks’ lending. In tandem, the Government imposed higher duties on the import of vehicles and a few other commodities, and increased the administratively determined prices of petroleum products. These measures were implemented in a carefully planned out and logical sequence.

As a consequence, the desired stability within the economy was achieved quickly, with the Balance of Payments returning to positive territory, and the exchange rate stabilizing. In fact, this new situation enabled the Monetary Board to relax the monetary policy tightening cycle that commenced in February 2012, as early as in December 2012.

This joint exercise therefore shows how quickly and effectively, a coordinated fiscal and monetary policy could deliver results.

Case study 7: Judicious use of fiscal policies, based on inflation behaviour and other macro-economic factors: I have so far discussed 6 case studies that confirm the co-operation and harmonisation between the MoF and CB. The co-ordination however, went even further and was applied in several other situations as well.

Now, I am going to describe one general example out of several similar instances which took place from time to time, over the past few years.

Let us take our minds back to October/November 2011. At that time, the global oil prices had soared to dizzy heights, and the Ceylon Petroleum Corporation was incurring rather heavy losses. As a natural response therefore, an increase in the administrated prices in petroleum products seemed like a sensible action. However, at that time, inflation in the country was around the seven percent level. Inflation projections for the next two months too, were around the seven percent to eight percent levels.

In that background, our view was that, if the petroleum prices were to be adjusted upwards significantly, the inflation figures would have risen above 10%, and had that happened, the favourable sentiments that had been built up carefully over the previous 33 months would have been badly damaged.

Then, we would have had to start our inflation control efforts all over again, and inflation expectations too would have suffered considerably.

So, a balance was struck and the decision to increase the petroleum prices was postponed until February 2012, because we knew that, by that time, the inflation figures would be very low, at less than 3 percent, and that benign situation would then give us a comfortable cushion to make the price adjustment, without harming the inflation numbers or the inflation outlook.

A “shared vision” and “goal congruence” I am often asked by people as to the exact definition of the economic philosophy behind our country’s economic policies. Where then would our current economic policy framework, fit in? Is there a particular model that Sri Lanka follows?

To respond to such questions, let us try to understand what exactly our economic planners are doing, and what they are attempting to achieve.

In my view and understanding, it is clear as to what our goals are, and I must say, there are quite a few: Maintain a low level of inflation; Consolidate the fiscal deficit on a planned basis; Promote SMEs; Ensure food security; Encourage import substitution; Enhance exports; Diversify our external sector by adding new areas to the external sector; Record a current account surplus by 2016; Deliver balanced regional development; Ensure that infrastructure development takes place in all parts of the country; Improve the way we do business; Consolidate our debt position; Encourage more savings; Eradicate poverty; Reduce unemployment to very low levels; Continuously maintain sufficient levels of foreign reserves; Improve the living standards of all the people.

What then would a collection of policies that are designed and are being implemented to deliver the above outcomes, be called? In all humility, I must admit, I don’t know.

That shared vision has been the platform that has helped the two institutions to achieve “goal congruence” in the recent past, and there is also no doubt that the resulting harmonisation has been the powerful driving force behind our steady progress.

In the meantime, we must also appreciate that a large segment of our economic activities are carried out by the private sector, to which many of you belong. Your contribution then, has also been a vital factor in maintaining the momentum and thrust of our economy.

Therefore, let me acknowledge today, that no amount of harmonization of Monetary and Fiscal policies could ever be a substitute for the commitment and dedication of a vast number of entrepreneurs who take risks, as well as burn the mid-night oil, to deliver value in our economy.

A finance man as Governor?

Let me now strike a slightly personal note before I proceed to conclude this address.

In order to do so, let me quote from what Exter had to say about the person to be selected as the Governor:” Although the ultimate authority rests in the Monetary Board, the draft law nevertheless recognises need for a strong chief executive for the Central Bank.

Accordingly, the Governor is made the Chairman of the Monetary Board, and is given control of the agenda for its meetings.

He is to be responsible for the execution and administration of policies and measures adopted by the Monetary Board, for the direction, supervision and control of the operations of the Central Bank, and for its internal management and administration. He is to be chief representative of the Bank in its relations with outside persons, …..Accordingly, the Governor should be a man of recognized and outstanding competence in, and understanding of, the economic and financial problems of Ceylon, and of unquestioned integrity and responsibility...

You may remember when I was first appointed Governor, there were some who claimed that a person with “financial experience”, and was not a suitable choice, to undertake the duties of the Governor. While I firmly believe it is up to history to judge as to whether I have been successful or not in discharging my responsibilities as Governor, I also believe that even at this late stage, it may be useful for those critics to reflect on the profile that John Exter had in mind for the position of Governor when drafting the MLA, and then perhaps consider, whether or not, I fitted the envisaged profile! In that background, I am inclined to believe that the education, training, and professional skills imparted by the Institute of Chartered Accountants of Sri Lanka, had a major role in my being appointed to this pivotal position as the Governor of the Central Bank of Sri Lanka.

Running between the wickets!

About six months ago, a journalist friend asked me to explain the official relationship between the Governor and the Secretary,

Treasury.

In response, I gave him a long lecture for about half an hour. While listening to me, I could see that he was quite restless, and somewhat bored. He then told me,“Governor, Can you please explain what you just said to me, in layman’s language?”

This was my reply to that challenging question: “To score runs in a cricket match, when one batsman strikes the ball, both batsmen have to run, each to their opposite ends. When the second batsman strikes the ball, once again, both batsmen have to run, each to their opposite ends. That is how the team will be able to accumulate its runs. For an effective partnership to be built, both batsmen have to diligently run for each other’s strikes.”

“In the same way, for an economic partnership of the country to succeed, it is vital that there is a clear understanding between the Governor and the Secretary, Treasury. And, each time the Governor strikes, both the Governor and the Secretary have to run, and when the Secretary strikes, both the Governor and the Secretary have to run once again. That is the type of relationship that has to exist between the Governor and the Secretary to the Treasury”.

My journalist friend’s eyes brightened and his boredom vanished. The expression on his face indicated to me that he had finally understood what this complex relationship is all about.

Then, he said “Ah, so it’s like running between the wickets!”