By: Staff Writer
October 10, Colombo (LNW): Sri Lanka is confronting significant challenges in its monetary policy due to an economic downturn and the ongoing impacts of the pandemic, as highlighted in a recent report by the International Monetary Fund (IMF).
A mission from the IMF South Asia Regional Training and Technical Assistance Center (SARTTAC) visited Colombo to offer guidance on developing liquidity monitoring tools aimed at enhancing the Central Bank’s oversight of domestic currency liquidity.
To transition to a flexible inflation-targeting approach, crucial for modern monetary policy, structural reforms are needed to stabilize the macroeconomic environment.
This includes ending monetary financing (government deficit funding by the central bank) and anchoring inflation expectations by keeping inflation low and stable. A systematic strategy is vital for modernizing monetary policy tools and operations.
The report emphasizes that these advancements depend on ongoing debt restructuring, managing financial risks, improving the Central Bank’s balance sheet, and stabilizing the wider economy. The modernization process involves multiple phases, with some actions prioritized while others are postponed until financial stability is achieved.
The IMF recommends that the Central Bank of Sri Lanka (CBSL) transition from using two policy rates to a single policy rate to better guide market interest rates and enhance communication about its monetary stance.
It also cautions against temporary restrictions on access to the central bank’s standing facilities, as this could hinder market-based interest rate adjustments and harm the central bank’s credibility.
As part of modernizing the interest rate framework, CBSL is advised to widen the Interest Rate Corridor (IRC) and reduce its monetary instruments supporting the local bond market, particularly for Sri Lankan Rupee bonds. Non-bank primary dealers should not access these instruments for financing bond market operations.
In the second reform stage, a transitional model for monetary operations focusing on weekly liquidity management is proposed, addressing liquidity needs across various market segments until the CBSL can target overall liquidity. Adjustments to reserve requirements will also be necessary as financial stability improves.
Future stages involve the CBSL managing overall liquidity through Open Market Operations (OMOs) aligned with liquidity forecasts, aiming to return to a mid-corridor system in accordance with monetary policy committee announcements.
The CBSL currently employs an operational liquidity forecasting tool based on daily data from its units and commercial banks. However, enhanced forecasting capabilities are needed, especially given the unique banking arrangements with government accounts. Improvements in forecasting tools, data formats, and daily balance sheet updates are essential for effective liquidity management.
As the financial system stabilizes, the Central Bank must implement these reforms with skilled staff and improved communication between monitoring and forecasting units, critical for successful inflation targeting and modernizing monetary policy, according to the IMF.
