Analysis of interest rate and monetary policy in Sri Lanka (1977 to up-to-date)

Introduction

Monetary policy is controlling of the availability and cost of liquidity in the economy with the intention of achieving certain macroeconomic goals including faster economic growth, higher level of employment, low inflation and balance of payment equilibrium.(Colombage, 1993)
The responsibility of operating monetary policy is held with monetary board in central bank of Sri Lanka by the monetary law act. Since establishment of central bank up to 2002 the monetary policy was operated with the objectives of stability of domestic value of money, stability of external value of money, to promote & maintain high level of production, high employment, real income & promote full development of the productive resources.(CBSL, 1990). Since those previous objectives made a conflict in monetary management in 2002 objectives of central bank has been reformulate as stability in price and economy, stability in financial system. Monetary policy of central bank is mainly focused on achieving price stability.
Monetary policy instruments.
Central bank of Sri Lanka uses different instruments to control the money supply of the economy. Those can be classified as,

1.Market intervention
a.Open market operations
b.Bank rate
2.Portfolio limits
a.Reserve requirements
b.Credit ceilings
3.Other instruments
a.Prior import deposits
b.Moral suasion

Open market operation, bank rate and reserve requirement are indirect type of control while credit ceilings, prior import deposits and moral suasion are direct type of controls. Though traditional central banks in developing countries used direct controls since lack of having a developed financial market, now many central banks including Sri Lanka using indirect instruments as monetary economists Argive that direct control instruments create market distortions and they are less effective compared to indirect ones.(Colombage, 1993)
After 1977 the Quasi money hold by people began to rise hugely. Quasi money consist mainly savings and time deposits. This mainly happen because of the positive real interest rate and liberalization of financial sector. In 1970 the M1 was 63.15% of M2. But when it comes to 1985 the percentage has been reduced up to 38.79%. And after introducing electronic payment systems the money in circulation of Sri Lanka become smaller portion in M2. In 2016 the money in circulation was 15.79% of M2 [Table1].(Colombage, 1993)
In closed economy model handling monetary policy is less complex compared to a liberalized one. Due to fixed exchange rate system and restrictive financial systems the control of money supply was less complex. So previous monetary authorities used interest rate, reserve requirement and credit control as main monetary policy instruments. And prior to 1977 the intermediate target of monetary policy framework was narrow money. After liberalized economy that lead to liberalized financial sector and relatively flexible exchange rate system, made monetary policy much more complex with previous policy instruments. So in 1984 CB shifted towards open market operation from interest bank rates & statutory reserve ratio in controlling money supply since those instruments failed to achieve desired outcomes. They were able to mop up the excess liquidity in the economy which had arisen from high tea prices & excessive government expenditure. Also in 1988 because of the savings and time deposits considered as much liquidity asset that directly affect money supply of economy, the intermediate target of monetary policy rearrange as broad money from narrow money.
In 1981 central bank introduced national credit plan (NCP) in the objective of setting monetary and credit targets with forecasting monetary bases. The NCP has prepared annually to guide monetary management of CB. Same year secondary market for treasury bills has been introduced that led to development of TB market.(Karunathilake, 2000)
In order to widening open market operations repurchase agreement system has been introduced in 1993. In reverse repo agreements central bank can sell treasury bills that in position with them to public with the agreement to buy back after a specified duration. In 1995 central bank introduced reverse repurchase agreement system in OMO.
Monetary board of CBSL is having the responsibility to handle monetary policy and in 2001 monetary policy committee (MPC) was appointed to advised monetary board by studying monetary aggregates within the economy. They meet monthly & evaluate economy & recommend suitable policies.
In 2003 active open market operation system introduces with many attractive functions. Establishing daily auction system, maintaining interest rate corridor with repo and reverse repo rates & Outright Sales/Purchases of government securities to address long term (structural) liquidity imbalances.(Wijesinghe, 2005)
In 2009 with the intension of accelerating economic activities the penal rate charged on reverse repo transactions when participating institution exceeded the maximum no of times that could access to reverse repo window in a month has been removed and the 100% margin deposit requirement  for opening letters of credit imposed in 2004 which later in 2008 raised up to 200%, is removed in 2009.

Future development
Since in 1980s central bank has adopted a monetary targeting framework to address the defined objective of enabling price stability by influencing monetary aggregates by addressing reserve money. But recent years with the weakening relationship between money and inflation several central banks whole around the world has adopted flexible inflation targeting policy instead of monetary targeting framework. Central bank of Sri Lanka now working to meet requirement of such framework that enable to shift at inflation targeting framework.(CBSL, 2010)

Prerequisites that needed for adapt Inflation targeting monetary policy.(Perera, 2007)
•CB should have independence specially in legally.( specially mandated to achieve price ability)
•Low and stable fiscal deficit with freedom from fiscal dominance.
•Well understood channels between policy instruments and inflation.
•Flexible exchange rate system.
•Effective inflation forecasting models.
•Developed financial system with policies that enhance transparency of central bank.

Interest rate
Interest rate liberalization
Before 1977 the interest rates were kept low in formal sector than organized sector by interest rate ceilings, subsidized credit allocation and high reserve ratio. This lead to have a negative real interest rate throughout the years before 1977. These financial repressions undertaken by central bank are removed through interest rate liberalization. This created a chance to formal financial sector to attract more deposits as well as could lend more to public. This reduced the effectiveness of interest rate as a policy instrument. (Colombage, 1993)
Since interest rate not allowed to adjust for inflation real interest were negative before 1977.with the raise of bank rate from 6.5% to 10% all commercial banks rose their deposit rate together. The 12 month fixed deposit rate was doubled from 7% to 14%. [Table 2]
Policy interest rates
Central bank uses bank rate, repurchase rate, reverse repurchase rate as policy interest rate which help to affect all other interest rate in market. Bank is not very active today since the penalty rate is high. Repo rate and reverse repo rate is the main policy rates CB used to affect to all other interest rates and ultimately on money supply by affecting interbank call money market liquidity.
Interest rate corridor
Central bank operates repo and reverses repo agreements to control the liquidity in call money market. The call money market rate adjusts according to the liquidity in the call money market. Repo and reverse repo rate act as a corridor to AWCMR. Before 2014 repo & reverse repo rate was determine by the auction bids. Later it was named as standard deposit facility rate & standard credit facility rate and rates have been determined by CB. [Figure2]
Limitations in monetary policy of Sri Lanka
•Less sensitivity of people to interest rates. [Figure 5]
•Commercial banks keeping excess reserves.
•Financial cost of statutory reserve.
oStatutory reserves held in CB does not creating any profit to commercial banks though the money raise by interest bearing sources.
•Continuous budget deficit of government.
•Underdeveloped money & capital markets.
•High volatility in exchange rate in Sri Lanka.
•External effects.(political influence)