Foreign Affairs

Single Digit Inflation For five Years: Now The Challenge Is To Get Out Of ‘Lowflation Trap’

By W.A Wijewardena –

Dr. W.A. Wijewardena

Dr. W.A. Wijewardena

Driving down CCPI through administrative measures

When the annual enhance in the price of living of typical consumers in Colombo and suburbs declined from three.5% in September to 1.six% in October 2014, the Central Bank could not hide its joy. In its press release on Inflation in October, the Bank has said that ‘inflation has declined significantly in October’ (obtainable at: Inflation declines significantly in October).

In additional elaborating this claim, the Bank has stated that “Inflation, as measured by the change in the Colombo Consumers’ Value Index (CCPI) (2006/07=100), which is computed by the Division of Census and Statistics, decreased from 3.5 per cent recorded in September 2014 to 1.six% in October 2014, on a year-on-year (YoY) basis, which is the lowest considering that November 2009”.

The downward revision of the ‘electricity tariff by 25% supported by comparable reduction in costs of LP gas, petrol and diesel’ by means of administrative decisions by the government in the last two months have been the primary motives for this decline in the price of living, according to the Central Bank. Because the products beneath reference together with rent on homes and water bills have a high weight of 24% in CCPI, even a minor reduction in the costs can result in a substantial fall in the all round CCPI worth in a specific month.

Hence, even though there was a marginal enhance in the food and non-alcoholic beverages in October, such improve could not influence the general index value regardless of it has a share at 41% in the index. Yet, the total expenditure which a customer has to incur in order to get the basket of goods and solutions in CCPI has improved, according to values provided by Division of Census and Statistics or DCS, from Rs. 49,259 a year ago to Rs. 50,070 in October 2014. However, the expenditure on this basket in September 2014 amounted to Rs. 50,881 and therefore there is a slight easing of the cost of living in October 2014.

The reductions in electrical energy tariff and the rates of power are not repeatable each and every month. Therefore, a repeat overall performance of this beneficial outcome in the coming months is unlikely.

Can the Central Bank be pleased about the development?

Ought to the Central Bank be happy about this improvement? For two causes, it ought to be a tiny far more restrained in expressing its happiness. One particular is that it does not go along with the Central Bank’s co-objective of ‘economic and cost stability’. The other is that it portends a larger extended term dilemma now know as ‘lowflation trap’.

Central Bank’s new mandate is to have both economic and price stability

Let’s now turn to the initial issue. In an amendment accomplished to the Bank’s governing legislation recognized as the Monetary Law Act in 2002, the Bank’s objective of maintaining a steady common price level in the economy was re-designated as ‘economic and value stability’. This is somewhat peculiar due to the fact in all other central banks, it is just maintaining price stability. Why this was accomplished in the case of the Central Bank of Sri Lanka was explained in detail by this writer in a preceding report in this series beneath title ‘Central Bank’s Mandate is to attain each financial and cost stability’ (offered here ).

Rajapaksa, Cabraal, Basil Rajapaksa speak during the presentation of the Central Bank of Sri Lanka annual report 2010, in ColomboThe broadening of the mandate to economic and price tag stability was due to the foresight of the then Governor of the Bank, A.S. Jayawardena, popularly identified as AS. When the Globe Bank, IMF and even this writer were opposed to the particular term, AS had a simple but a very cogent explanation. He mentioned that what a central bank must seek to attain is the stability in the general macroeconomy and not a mere price index. Simply because, according to him, a cost index can be manipulated to record a slower development via value controls, subsidies or mere price tag reductions carried out administratively. Such measures will certainly ease the burden of expense of living. But they will not assist a central bank simply because these actions develop imbalances elsewhere creating it difficult for a central bank to attain its objective of maintaining a stable economy.
The purpose of adding the term ‘economic’ is, therefore, to remind the future central bankers that they ought to not be content about a mere decline in the consumers’ price index. They need to be satisfied only when such decreases have come from the monetary policy actions taken by the Bank without generating imbalances elsewhere in the economy.

Reduction of rates of loss makers creates concerns for the fiscal sector

The present reductions in electrical energy tariff and rates of LP gas, petrol and diesel by means of administrative measures do not fall in line with the above financial wisdom. Except LP gas, the other three item supplying companies in Sri Lanka are running at a enormous loss as documented by the Committee on Public Enterprises or COPE in its current reports to Parliament. Accordingly, the cumulative losses of the electricity supplier, CEB, during 2011-13 had amounted to Rs. 47 billion and these of the fuel supplier, CPC, had amounted to Rs. 193 billion.

These losses have to be recouped by the Treasury by raising funds either by means of increased taxation or by borrowing. What the Treasury has done in the past to make good these losses is to situation particular Treasury bonds to these institutions which the public has to repay on a future date by paying much more taxes or foregoing existing public services. Thus, there is already an imbalance in the fiscal sector of the nation. Therefore, the present cost reductions involving loss-creating public enterprises and thereby worsening the fiscal imbalance are not a development about which the Central Bank could be happy if it follows its mandate properly.

Lack of credit development despite inducements

Sri Lanka has knowledgeable a deceleration in the growth of its customer value index, CCPI, from around late 2009. The long term inflation shown by this deceleration became a single digit quantity and that single digit number also started falling over the years. What is shown as 1.six% growth in CCPI in October 2014 for the duration of the final 12-month period is the lowest worth of the single digit number ever recorded in the final five years. Responding to the decline in the single digit number, the Central Bank commenced relaxing its monetary policy with an announced objective of supporting the government’s economic growth initiatives. This was completed in a number of rounds in diverse forms.

Credit expansion in the economy was promoted explicitly by the Central Bank by releasing a substantial amount of money which industrial banks had to keep with the Central Bank as a compulsory reserve – recognized as the Statutory Reserve Requirement or SRR – in July 2013 by lowering the necessary ratio from 8% to 6%. The quantity so released was about Rs. 590 billion which if banks had employed for credit expansion would have generated added loans of Rs. two,950 billion by about December 2014.

But this did not occur. Credit to private sector elevated only by Rs. 21 billion among July 2013 and July 2014. In reality, credit to public corporations declined by Rs. 37 billion more than this period. Even the lending to government by commercial banks did not increase appreciably it improved only by Rs. 53 billion after the changes in government deposits with industrial banks are netted off. Despite the reported high financial growth of over 7% during this period, naturally the private sector did not wish to utilise bank credit for financing their activities.

As a result, in a desperate attempt to push credit to the economy, the Central Bank commenced lowering interest prices by cutting its rate on excess money deposited by commercial banks from 7.5% to 6.5%. Typical fixed deposit prices of industrial banks fell from 12.38% in October 2013 to 8.09% in October 2014. Amongst September 2013 and September 2014, the average lending rates of industrial banks fell from 15.52% to 12.98%. Regardless of the cut in interest prices, industrial bank credit flows to the economy did not improve by the magnitudes by which they ought to have elevated. It just appeared that the fall in lending prices of commercial banks was not a enough inducement for borrowers to raise funds from banks.

A country in a lowflation trap

This predicament evidences that Sri Lanka is caught up in a ‘lowflation trap’, a malaise at present being seasoned by EU countries. When the inflation price comes down sharply and holds at those low levels for some time, there ought to be a faster reduction in lending prices to produce a decline in true lending prices – the necessity for inducing borrowers to use bank credit.

When the average inflation rate was at 23% in 2008, the typical lending prices of commercial banks were about 20%, yielding a damaging actual lending price in the economy on typical. It is a substantial inducement for borrowers to borrow. But when the inflation rate fell, lending rates of industrial banks did not fall in the identical style. Accordingly, when the typical inflation price was around 7% at end-2013, the average lending rates of commercial banks stood at 15%. The actual interest rates in terms of these numbers had been substantially optimistic at about 8% – certainly not an inducement for borrowers to seek funds from industrial banks. By September 2014, on the insistence of the Central Bank that industrial banks must reduce their lending rates, the typical lending rate fell to about 13% but inflation had fallen much more sharply to 3.5% by that time. Therefore, the actual interest rate had increased to 9.5%.

In October 2014, the situation has turn into a lot much more vital: Inflation rate has fallen further to 1.6% escalating the true lending rates to over 10%. In this situation, banks can not be blamed for not giving loans to clients because consumers have no incentive to seek bank credit at higher true interest prices.

To reduce or not to reduce interest rates?

If inflation rate remains under three% over the next two to 3 years, Sri Lanka can not get out of the lowflation trap unless it cuts its interest rates drastically by about five to 6%. This signifies Central Bank’s standard deposit price need to be about 1%, its common lending rate around two%, 1-year Treasury bill rate around two%, commercial bank deposit prices about three% and industrial bank lending prices about 6%. But that will produce severe imbalances across the economy thereby frustrating Central Bank’s try at attaining each financial and cost stability. It may possibly solve a issue in 1 area but it might generate many far more troubles in other regions. In other words, an artificially driven-down inflation rate will not help the Central Bank to preserve macroeconomic stability across the economy.

A low interest rate regime at around the levels talked about above is not feasible in Sri Lanka due to three factors.

CCPI numbers coming out of a black box

In the first spot, there are issues about the credibility of the inflation numbers released by DCS. Considering that the entire approach of preparing CCPI is not topic to a post-audit verification by a technically competent authority, the numbers are just released by DCS from out of a black box. What is taking place inside the black box is not visible to anyone. For instance, in October 2014, one particular of the reasons adduced for the decline in CCPI has been the so known as reduction in electricity tariff. But the actual electricity bills received by consumers for the month of October did not show such a reduction. In the case of this writer’s monthly electricity bill, per unit tariff for 200 units had enhanced from Rs. 21.25 in September 2014 to Rs. 23.91 in October 2014.

It is not clear no matter whether DCS had taken into account the actual electricity bills paid by the group of buyers represented in CCPI – the very first 80% of the expenditure units in Colombo and suburbs – or just gone by the announcement made by the government. Therefore, the ordinary public appears to be harbouring the belief that the CCPI numbers released by DCS are far from reality.

In such a scenario, the demand for greater wages, salaries, allowances and fees can’t be avoided. A lot of of the reliefs provided to the public in the Price range 2015 – enhance in the salaries of public servants, requesting the private sector do the very same, increase in the Mahapola scholarship allowances, payment of a special subsidy to senior citizens on their savings with banks – have been created in recognition of the elevated cost of living in spite of the deceleration in inflation price as calculated by DCS.

Artificially-low interest rates will worsen the external sector imbalances

Second, if inflation numbers are not realistic, the reduction in interest prices will certainly discourage savings and induce consumption and for that matter, the consumption of imported goods. This is shown by the higher registration of motor vehicles in the current previous, specifically motorbikes where much more than 1,500 motorbikes are registered per working day. Hence, a low interest rate regime is like providing a blank cheque to somebody as far as consumption and imports are concerned. Regardless of the deceleration in the growth of imports and better overall performance in exports, this year’s trade deficit is probably to be around $ 8 billion. Thus, a blank cheque by way of lowered interest prices will worsen the current imbalance in the external sector requiring the nation to borrow more to fill the gap.

Low interest prices not great for foreign hot income

Third, Sri Lanka has relied on foreign hot money to build its foreign reserves by permitting foreigners to invest in higher yielding government paper. Such funds, amounting to $ 3.5 billion as at end October and accounting for about 40% of total official foreign reserves, have been attracted by Sri Lanka primarily by supplying greater yields on government securities when in the home nations of these investors, the maximum yield receivable has been about 1%. This incentive will be narrowed and ultimately be unfavorable if Sri Lanka reduces its interest prices to a low level. In such a scenario, the outflow of these funds can not be avoided worsening the existing imbalance in the external sector. It will put stress on the rupee to further depreciate with adverse consequences on Sri Lanka’s future development plans.

In view of the lowflation trap in which Sri Lanka is now caught, the decline in the price of growth in CCPI is not a development about which the Central Bank can be content at all.

W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected]

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