Single digit inflation for 5 years: Now the

challenge is to get out of Lowflation Trap

November 17, 2014
Driving down CCPI through administrative measures
When the annual increase in the cost of living of average consumers in Colombo
and suburbs declined from 3.5% in September to 1.6% 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 considerably in October (available at:
Inflation declines considerably in October).
If

inflation numbers are not realistic, the reduction in interest rates will surely
discourage savings and induce consumption and for that matter, the consumption
of imported goods. This is shown by the high registration of motor vehicles in the
recent past, especially motorbikes where more than 1,500 motorbikes are
registered per working day

In further elaborating this claim, the Bank has said that Inflation, as measured by
the change in the Colombo Consumers Price Index (CCPI) (2006/07=100), which
is computed by the Department of Census and Statistics, decreased from 3.5 per
cent recorded in September 2014 to 1.6% in October 2014, on a year-on-year
(YoY) basis, which is the lowest since November 2009.
The downward revision of the electricity
tariff by 25% supported by similar
reduction in prices of LP gas, petrol and
diesel through administrative decisions by
the government in the last two months
have been the main reasons for this
decline in the cost of living, according to
the Central Bank. Since the items under
reference together with rent on houses and
water bills have a high weight of 24% in
CCPI, even a minor reduction in the prices
can cause a substantial fall in the overall
CCPI value in a particular month.
Thus, though there was a marginal increase
in the food and non-alcoholic beverages in
October, such increase could not influence
the overall index value despite it has a
share at 41% in the index. Yet, the total
expenditure which a consumer has to incur
in order to buy the basket of goods and
services in CCPI has increased, according
to values given by Department 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 electricity tariff and the prices of energy are not repeatable
every month. Hence, a repeat performance of this beneficial outcome in the
coming months is unlikely.

Can the Central Bank be happy about the development?

Should the Central Bank be happy about this development? For two reasons, it
should be a little more restrained in expressing its happiness. One is that it does
not go along with the Central Banks co-objective of economic and price stability.
The other is that it portends a bigger long term problem now know as lowflation
trap.
Central Banks new mandate is to have both economic and price stability
Lets now turn to the first issue. In an amendment done to the Banks governing
legislation known as the Monetary Law Act in 2002, the Banks objective of
maintaining a stable general price level in the economy was re-designated as
economic and price stability. This is somewhat peculiar because in all other
central banks, it is just maintaining price stability. Why this was done in the case
of the Central Bank of Sri Lanka was explained in detail by this writer in a previous
article in this series under title Central Banks Mandate is to attain both economic
and price stability (available at: http://www.ft.lk/2011/10/10/central-bank
%E2%80%99s-mandate-is-to-attain-both-E2%80%98economic%E2%80%99-and%E2%80%98price%E2%80%99-stability/).
The broadening of the mandate to economic and price stability
was due to the foresight of the then Governor of the Bank, A.S.
Jayawardena, popularly known as AS. When the World Bank, IMF
and even this writer were opposed to the particular term, AS had a
simple but a very cogent explanation. He said that what a central
bank should seek to achieve is the stability in the overall
macroeconomy and not a mere price index. Because, according to
him, a price index can be manipulated to record a slower growth
through price controls, subsidies or mere price reductions done
administratively. Such measures will definitely ease the burden of
cost of living. But they will not help a central bank because those
actions create imbalances elsewhere making 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 should not be happy about a mere decline in the
consumers price index. They should be happy only when such decreases have

come from the monetary policy actions taken by the Bank without creating
imbalances elsewhere in the economy.
Reduction of prices of loss makers creates issues for the fiscal sector
The current reductions in electricity tariff and prices of LP gas, petrol and diesel
through administrative measures do not fall in line with the above economic
wisdom. Except LP gas, the other three product supplying businesses in Sri Lanka
are running at a massive loss as documented by the Committee on Public
Enterprises or COPE in its recent reports to Parliament. Accordingly, the
cumulative losses of the electricity supplier, CEB, during 2011-13 had amounted
to Rs. 47 billion and those of the fuel supplier, CPC, had amounted to Rs. 193
billion.
These losses have to be recouped by the Treasury by raising funds either through
increased taxation or by borrowing. What the Treasury has done in the past to
make good these losses is to issue special Treasury bonds to these institutions
which the public has to repay on a future date by paying more taxes or foregoing
existing public services. Thus, there is already an imbalance in the fiscal sector of
the country. Hence, the current price reductions involving loss-making 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 growth despite inducements
Sri Lanka has experienced a deceleration in the growth of its consumer price
index, CCPI, from around late 2009. The long term inflation shown by this
deceleration became a single digit number and that single digit number too
started falling over the years. What is shown as 1.6% growth in CCPI in October
2014 during the last 12-month period is the lowest value of the single digit
number ever recorded in the last 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 governments economic growth
initiatives. This was done in a number of rounds in different forms.
Credit expansion in the economy was promoted explicitly by the Central Bank by
releasing a substantial amount of money which commercial banks had to keep
with the Central Bank as a compulsory reserve known as the Statutory Reserve
Requirement or SRR in July 2013 by reducing the required ratio from 8% to 6%.
The amount so released was about Rs. 590 billion which if banks had used for

credit expansion would have generated additional loans of Rs. 2,950 billion by
about December 2014.
But this did not happen. Credit to private sector increased only by Rs. 21 billion
between July 2013 and July 2014. In fact, credit to public corporations declined by
Rs. 37 billion over this period. Even the lending to government by commercial
banks did not increase appreciably; it increased only by Rs. 53 billion after the
changes in government deposits with commercial banks are netted off. Despite
the reported high economic growth of over 7% during this period, obviously the
private sector did not wish to utilise bank credit for financing their activities.
Thus, in a desperate attempt to push credit to the economy, the Central Bank
commenced lowering interest rates by cutting its rate on excess money deposited
by commercial banks from 7.5% to 6.5%. Average fixed deposit rates of
commercial banks fell from 12.38% in October 2013 to 8.09% in October 2014.
Between September 2013 and September 2014, the average lending rates of
commercial banks fell from 15.52% to 12.98%. Despite the cut in interest rates,
commercial bank credit flows to the economy did not increase by the magnitudes
by which they should have increased. It just appeared that the fall in lending rates
of commercial banks was not a sufficient inducement for borrowers to raise
money from banks.
A country in a lowflation trap
This situation evidences that Sri Lanka is caught up in a lowflation trap, a
malaise currently being experienced by EU countries. When the inflation rate
comes down sharply and holds at those low levels for some time, there should be
a faster reduction in lending rates to generate a decline in real lending rates the
necessity for inducing borrowers to use bank credit.
When the average inflation rate was at 23% in 2008, the average lending rates of
commercial banks were around 20%, yielding a negative real lending rate in the
economy on average. It is a substantial inducement for borrowers to borrow. But
when the inflation rate fell, lending rates of commercial banks did not fall in the
same fashion. Accordingly, when the average inflation rate was around 7% at end2013, the average lending rates of commercial banks stood at 15%. The real
interest rates in terms of these numbers were substantially positive at about 8%
surely not an inducement for borrowers to seek funds from commercial banks. By
September 2014, on the insistence of the Central Bank that commercial banks
should cut their lending rates, the average lending rate fell to about 13% but

inflation had fallen more sharply to 3.5% by that time. Thus, the real interest rate
had increased to 9.5%.
In October 2014, the situation has become much more critical: Inflation rate has
fallen further to 1.6% increasing the real lending rates to over 10%. In this
situation, banks cannot be blamed for not giving loans to customers since
customers have no incentive to seek bank credit at high real interest rates.
To cut or not to cut interest rates?
If inflation rate remains below 3% over the next two to three years, Sri Lanka
cannot get out of the lowflation trap unless it cuts its interest rates drastically by
about 5 to 6%. This means Central Banks standard deposit rate should be around
1%, its standard lending rate around 2%, 1-year Treasury bill rate around 2%,
commercial bank deposit rates around 3% and commercial bank lending rates
around 6%. But that will create serious imbalances across the economy thereby
frustrating Central Banks attempt at attaining both economic and price stability.
It may solve a problem in one area but it may create many more problems in
other areas. In other words, an artificially driven-down inflation rate will not
support the Central Bank to maintain macroeconomic stability across the
economy.
A low interest rate regime at around the levels mentioned above is not feasible in
Sri Lanka due to three reasons.
CCPI numbers coming out of a black box
In the first place, there are issues about the credibility of the inflation numbers
released by DCS. Since the whole process of preparing CCPI is not subject 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 happening inside the black box
is not visible to anyone. For instance, in October 2014, one of the reasons
adduced for the decline in CCPI has been the so called 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 writers monthly
electricity bill, per unit tariff for 200 units had increased from Rs. 21.25 in
September 2014 to Rs. 23.91 in October 2014.
It is not clear whether DCS had taken into account the actual electricity bills paid
by the group of consumers represented in CCPI the first 80% of the expenditure
units in Colombo and suburbs or just gone by the announcement made by the

government. Thus, 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 higher wages, salaries, allowances and fees
cannot be avoided. Many of the reliefs given to the public in the Budget 2015
increase in the salaries of public servants, requesting the private sector do the
same, increase in the Mahapola scholarship allowances, payment of a special
subsidy to senior citizens on their savings with banks have been made in
recognition of the elevated cost of living despite the deceleration in inflation rate
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 rates will
surely discourage savings and induce consumption and for that matter, the
consumption of imported goods. This is shown by the high registration of motor
vehicles in the recent past, especially motorbikes where more than 1,500
motorbikes are registered per working day. Hence, a low interest rate regime is
like giving a blank cheque to someone as far as consumption and imports are
concerned. Despite the deceleration in the growth of imports and better
performance in exports, this years trade deficit is likely to be around $ 8 billion.
Thus, a blank cheque by way of lowered interest rates will worsen the existing
imbalance in the external sector requiring the country to borrow more to fill the
gap.
Low interest rates not good for foreign hot money
Third, Sri Lanka has relied on foreign hot money to build its foreign reserves by
permitting foreigners to invest in high 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 mainly by offering
higher yields on government securities when in the home countries of those
investors, the maximum yield receivable has been around 1%. This incentive will
be narrowed and finally be negative if Sri Lanka reduces its interest rates to a low
level. In such a scenario, the outflow of these funds cannot be avoided worsening
the current imbalance in the external sector. It will put pressure on the rupee to
further depreciate with adverse consequences on Sri Lankas future growth plans.
In view of the lowflation trap in which Sri Lanka is now caught, the decline in the
rate of growth in CCPI is not a development about which the Central Bank can be

happy at all.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka,
can be reached at waw1949@gmail.com.)