Central Bank Ajith Nivard Cabraal said that inflation is too high and that the Central Bank is highly concerned about it, but said that the present economic situation was a challenging one that can be faced if right steps are taken."We are pursuing a very tight monetary policy to rein in the inflation and inflation expectation. If the Central Bank fails to tighten monetary policy by imposing tough limits on reserve money and thereby allowing the interest rate to rise, not only the industrial sector but also the whole country will face more difficulties than currently being experienced," Cabraal said.
He said that in the present context if wages were to increase it could lead to spiralling cost-push inflation as it would add up to costs of goods and services and may not result in a net-gain.
Cabraal pointed out that out of the 33 million barrels of oil imported annually, 35 percent of it was used to generate electricity and about 50 percent of it was used on transport. If the country could somehow conserve at least 3 million barrels it would amount to a savings of US $ 300 million, he said.
A full report of the interview the Central Bank Governor follows.
Q: The surge in world oil prices affects all countries and is not a problem unique to Sri Lanka. However, what will be the impact on the economy?
As you rightly mentioned the rising oil and commodity prices are affecting all countries across the globe. But the magnitude of the impact may vary from country to country depending on the domestic economic structure and the endowment of economic resources. For instance, rising oil prices will increase the income of oil exporting countries by transferring income from oil importing countries through higher import expenditure on oil imports. The international crude oil prices, which were in the range of US dollars 60-65 per barrel during May 2007 has more than doubled to US dollars 135 per barrel in May 2008. In this context, Sri Lanka as a 100 per cent oil importing country has to pay in foreign currency the double the amount spent on oil imports in 2007. However, the impact of rising import expenditure on the exchange rate is largely mitigated by the increased foreign exchange earnings from exports of goods and services, higher remittances from migrant Sri Lankans, higher capital flows to the government and concessional supplier’s credit extended by the Government of Iran. Therefore, the impact of rising oil prices on exchange rate and BOP has been mitigated to a certain extent. However, as an oil importing nation we must strive to save valuable foreign exchange by economizing the use of petroleum products and energy consumption. Currently, we import around 33 million barrels equivalent of crude and refined petroleum products annually, of which around 35 per cent is used for power generation, 50 per cent for transportations and the rest for the industrial and other purposes. If we could conserve say at least 3 million barrels per annum we could easily save a minimum of US dollars 300 million, which will help the external sector in a great way.
The government has rightly passed on the increased international prices to consumers who actually consume the petroleum products rather than giving subsidies through taxing all citizens, irrespective of who consume those products. This measure avoids the inflationary government borrowings and hence helps to rein in the future inflation and inflation expectation and avoids those who do not consume petroleum products from subsidizing petroleum users. This of course invariably lead to higher transportation cost, higher input cost and overall price increase in the economy causing higher inflation. As a result, the cost of production may increase posing a challenge to exports, which may lead to an improvement of productivity.
I must admit that the rising international oil and commodity prices have posed numerous challenges to both the Government and the Central Bank and we had to take tough decisions to deal with the emerging situation. But that has been done in order to mitigate the adverse impact that the rising oil prices would have on the economy in the medium to long term.
Q: Most people ask these days: is our economy in trouble? How would you answer as the Governor of the Central Bank?
I would say we are facing one of the toughest challenges today. But as to whether we are in trouble, I would say it is a challenge that we can face, if we take the right steps. If you carefully look at the performance of various economic fundamentals during the first few months of 2008 you will realize that there is no truth in what some politically motivated pessimists cry about the economy. However, I must admit that the current inflation is too high and that we are highly concerned about it. I am sure, you are aware that we are pursuing a very tight monetary policy to rein in the inflation and the inflationary expectation. During the first quarter, agriculture sector, industrial sector and services sector have performed well and we expect this trend to continue during the remainder of the year. For instance, during the first quarter, the export earnings increased by around 10 per cent, tea production increased by around 30 per cent, worker remittances increased by 23 per cent, both fixed line and cellular phone connections grew by around 44 per cent, total cargo handling increased by 9 per cent, the balance of payment registered a surplus of around US dollars 450 million and the gross official reserves increased to US dollars 3.5 billion. Both exchange rate and interest rates have been more stable in 2008 than in 2007. According to the 2006/2007 Household Income and Expenditure Survey conducted by the Census and Statistics Department, Sri Lanka’s poverty level has declined to 15.2 per cent compared with 26.1 per cent recorded in 1990/1991 survey. This is the true picture. So, even in a challenging environment both domestically and internationally we have been able to achieve these developments.
Q: How will industries be affected? As it is, high interest rates, tax rates are affecting them, especially the SME sector.
The Central Bank of Sri Lanka (CBSL) is fully aware of the impact of current high interest rates on the industrial sector, particularly to Small and Medium Enterprises (SMEs). However, by law we are expected to maintain economic and price stability as the first core objective of the CBSL. What it means is CBSL has a responsibility to secure low inflation in the country. Due to rapidly increasing petroleum and other essential commodity prices, and other shocks, headline inflation has been increasing beyond our expectations. Therefore, to arrest the trend of increasing inflation by avoiding the second round impacts of high headline inflation, CBSL is adopting a tight monetary policy. If the CBSL fails to tighten the monetary policy by imposing tough limits on reserve money growth and thereby allowing the interest rate to rise, not only the industrial sector but also the whole country will face more difficulties than currently being experienced. At the same time, it must also be noted that based on the industrial production survey, the cost of interest as a percentage of total cost of production is less than 5 per cent. Further, industrialists are aware that the government has granted several tax holidays and incentives and has special programs for industrial development and investment promotion. With the concerns of the development of industrial sector including SMEs, government has also taken several initiatives to mitigate the tax and interest rate issues by providing special incentives on tax and interest rates through the Board of Investment (BOI), Sri Lanka Export Development Board, Lankaputhra Development Bank and through special industrialisation programs such as "Nipayum Sri Lanka" 300 factory industry program, Gamata Karumantha regional industrialisation program and Negenahira Navodaya . Duty free concessions to import high tech machinery and equipment to enhance the production capacity of local enterprises, concessionary loans subject to a maximum of Rs.15 million at an interest rate of 10 per cent for small and medium scale garment factories situated outside the Colombo district to enable modernization, financial assistance at concessionary rates for SMEs including diary, fishery, livestock and textile industries from the National Co-operative Fund were among the Buidget-2009 proposals intended to steer SME sector.
Q: Some exporters say that our currency is over-valued and affect the value addition as inputs are imported? What are your comments?
As you know since 2001 the country adopted a floating exchange rate regime, allowing market forces greater flexibility in determining the exchange rate. Unlike previous fixed exchange rate regime, the CB has no major role in terms of exchange rate determination other than monitoring the movements of the rate. The current system is often called self-correcting, as any differences in supply and demand will automatically be adjusted by changing the existing rate. In recent months under the floating exchange regime, the Sri Lanka rupee no longer depreciates at a steady pace against major currencies but appreciates responding to market forces of supply and demand in determining the exchange rate with limited intervention by the Central Bank to mitigate excessive volatility in the market. It is usually payments required for imports of goods and services and for capital payments that constitute demand for a currency while supply of a currency is determined by the exports of goods and services, worker remittances and capital inflows. It is true that the current level of currency may appear overvalued to exporters, compared to the levels in September 2007. But this is purely due to market factors that drove the exchange rate to current level. The Central Bank is also concerned about any sharp appreciation of rupee against major currencies and therefore sometimes intervenes in the market to prevent too rapid an appreciation. If not for the Central Bank’s interventions, the exchange rate may have even been appreciated more.
Q: Inflation, high interest rates, an overvalued rupee. How is the Central Bank taking care of these issues?
This is a good question. Managing all these macroeconomic variables simultaneously is not a simple job. Not only inflation, interest rates and exchange rate, the Central Bank should also be conscious of economic stability while balancing growth. Dealing with high inflation certainly is a priority and that requires high interest rates. If not, it will further expand money supply with higher demand for goods and services leading to even higher inflation in the future. But, at the same time, we can’t squeeze the economy too much. If we do so, growth will be affected severely, while poverty may increase and unemployment may rise. If interest rates are too high, it may also conflict with our second objective, financial system stability. Therefore, we have to balance the interest rate movement, while primarily targeting inflation. You have used the term overvalued rupee. The Sri Lankan rupee has appreciated only by 0.76 per cent during this year. This is partially reflecting the depreciation of US dollar against other major international currencies. It is also due to capital flows to the country. Some people are happy with this movement, while other groups, particularly exporters, may complain that the rupee is not depreciating sufficiently. The sharp depreciation of the Sri Lankan rupee could fuel the already high inflation which could affect more adversely on interest rates, wages and cost of production. At the same time, you have to note that the prices of export commodities have increased in US dollar terms, which partly compensates rising cost of production.
Q: What can industries and the people of the country expect, apart from increasing prices, in the near future and in the long run?
As you mentioned, price increase may occur in the near future, due to external factors. But, fortunately, the situation would not remain so forever. International prices may not come down soon, but yet they would not increase at the same rate continuously. Therefore, inflation, change in prices, will diminish gradually when the impact of the current acute external shock phases out. We can now notice the impact of our past monetary policy. We are therefore now able to achieve our tight reserve money targets comfortably. Broad money growth has now decelerated to 13.7 per cent from the high levels of over 20 per cent. The same trend can be seen in growth in private sector credit. These are signs of reduced demand pressures. Core inflation is only 9.4 per cent, even though the headline inflation is much higher. Technically, headline inflation has to stabilize at the level of core inflation when the supply side impact is over. When this happens industries and people of the country can expect low interest rates. But, they have to bear with the high interest rates until the inflation trend turns the other way. Let me reiterate that the long-term prospects for the country are favourable and then we will be able to maintain a high growth, reduce unemployment, reduce poverty and reduce regional disparities further.
Q: The demand for wage increases is inevitable? How will this affect the economy?
Wage pressures are certainly a challenge for our efforts to bring inflation down. Inflation is a result of a macroeconomic imbalance. The adjustment process of this imbalance is painful. The more we avoid the pain, the less the speed of adjustment. In other words, if there are too much wage increases, it could lead to spiralling cost-push inflation. Even though, the wage earners can be happy for few months, finally it will add up to costs of goods and services and there may not be any net gain. So, everyone has to make some sacrifice, if we have to come out of this trap.
Q: Corruption and inefficiency of the state, public institutions. What kind of effect does it have on our economy?
If we first look at the second issue, that is the inefficiency, many agree that the state of some public institutions or even many of our private institutions is not at a level conducive for efficient delivery of public services. Hence, there is no doubt that the efficiency of institutions has to be improved. To do that, the identification of the causes for these inefficiencies is very important. Then only the appropriate measures could be introduced to strengthen the efficiency. If we look at the reasons, we would find that a series of factors including deficiencies in deployment of employees, issues related to managerial capabilities, problems related to attitudes, lack of willingness and ability to change, and inadequate systems, are responsible for these inefficiencies. I believe that the government and the private sector already know this situation and are in the process of implementing various programmes to improve the efficiency of public and private institutions. Separate institutions, such as Strategic Enterprises Management Agency (SEMA), have also been established for the very purpose of improving efficiency of the strategically important public institutions.
On the issue of corruption, no one will deny the fact that there may be such instances. From the time I can remember, the allegations of corruption in the public sector has been prevalent. At the same time, we should not forget the fact that we are now in the process of implementing a huge development initiative, which is essential for Sri Lanka’s growth in the future and is important facet of the development of the country. Hence, a large amount of funds associated with these projects have to be handled by the government. If that is the case, the chances of certain leakages from the process may arise and these would have to be dealt with. At the same time, I don’t think that there is any country in the world that is entirely free from corruption and if we stop all development work because there are allegations of corruptions may also have adverse repercussions in the long term.
What is important in this context is the level of corruption and the confirmation of its prevalence. We have seen that more often, various interest groups make a huge noise about the widespread corruption practices in public institutions in general and in the entire political system in particular. However, available evidence indicates that many of these allegations have not been proved to be true in all the times. Fortunately, we have relatively strong institutional mechanisms, including the judiciary, police, and Bribery and Corruption Commission, to deal with the potential corrupt practices. The Parliament is also concerned about the corruption in general. In addition, various civil groups maintain their vigilance on this issue. If all these efforts also continue strongly, we would be able to deal with corruption to a satisfactory extent.
