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FINANCIAL CHRONICLE™ » DAILY CHRONICLE™ » Sri Lanka has to keep inflation in mid single digits to grow: CB Governor

Sri Lanka has to keep inflation in mid single digits to grow: CB Governor

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Malika1990

Malika1990
Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
Sept 21, 2012 (LBO) - Sri Lanka has to keep inflation in mid single digits to keep interest rates in single digits helping keep annual economic growth around 8.0 percent, Central Bank Governor Nivard Cabraal said.

The index has briefly moved above mid single digits in the past few months peaking at 9.8 percent in July, after the rupee fell from 110 to 134 to the US dollar due balance of payments trouble brought on by sterilized foreign exchange sales.
The currency has now strengthened to 131.60 levels to the US dollar.

Sri Lanka has now had 43 months of single digit inflation, Cabraal said.

Stable Foundation

"The significance of that is not realized by many people, when you say we had 43 months of single digit inflation," Cabraal told an economic forum organized by Bloomberg newswires.

"The only other period of some comparison was the 23 months of inflation in the early 2000s.

"Other than that Sri Lanka has traditionally been a country with high inflation and we had almost begun to feel comfortable with 10, 12, 15, 20 percent inflation."

A central bank, which has a monopoly in circulated currency under legal tender laws, is the only is the only agency that can either generate inflation by printing money to keep interest rates down or control inflation by allowing rates to move according to credit demand.

Unless multiple currencies are allowed by relaxing legal tender laws - like in post-hyperinflation Zimbabwe - no amount of productivity gains or hard work by citizens, or any so-called 'positive supply shocks' can overcome the currency depreciation and inflation generated by a central bank.

Sri Lanka's post-2000 episode of low inflation also came in the wake of a balance of a payments crisis, an economic condition related to central banks which try to defend a peg while also printing money.

Peg Protection Thought a balance of payments crisis is brought on by money printed to sterilize foreign exchange sales sold to defend a dollar peg, as the crisis gathers pace, less-than-100-percent sterilization of forex sales cause liquidity shortages.

Liquidity shortages force rates upward, breaking credit growth, allowing inflation to fall and the economy to stabilize again. In Sri Lanka, the crisis also forced authorities to reduce man unproductive credit taken by state enterprises to manipulate energy prices.

In the 1999/2000 crisis, inflation topped 16 percent before moving down to almost zero amid gentle appreciation of the currency peg in the ensuing two years.

During a 2008/2009 balance of payments crisis, inflation neared 30 percent, worsened by record global inflation generated by reserve currency central banks, before moving sharply down, amid a global credit collapse which send commodity prices plunging down.

In a post-balance of payments crisis period, gentle appreciation of the currency also helps ward off any inflation generated by reserve currency central banks.

Until 1951 Sri Lanka had a currency board, a mechanism where interest rates automatically adjusted to keep the exchange rate from depreciating without state intervention and inflation was kept low, because the monetary authority has no money printing power.

A central bank that acts quickly to keep inflation in low single digits will be able to avoid balance of payments trouble, the same way old style currency boards did.

Last Defence

Classical economists have said that without peg defence and balance of payments crises, a true central bank will continue to depreciate the currency, generate continuous high inflation, impoverish the population and destroy lifetime savings.

"One virtue of fixed rates, especially under gold but even to some extent under paper, is that they keep a check on national inflation by central banks," wrote US economist Murray Rothbard, a foremost critic of the US Federal Reserve.

"The virtue of fluctuating rates - that they prevent sudden monetary crises due to arbitrarily valued currencies - is a mixed blessing, because at least those crises provided a much needed restraint on domestic inflation."

Meanwhile Cabraal said investors used to question him about the high levels of past inflation in the country.

"I said perhaps we had got used to having a temperature of 104 degrees and we live with it," he recalled.

"But when we get to normal temperatures you realize how important it is to have a normal temperature. And today people are beginning to realize what it means to have reasonable inflation in a country that is growing fast and not to grow too much beyond."

Growth Track

If the economy is to grow to 100 billion US dollars by 2016 with per person gross domestic product at 8.0 percent a year, as targeted by authorities, inflation has to be kept in mid single digits, he said.

"Sometimes it may go up and down slightly but by and large for an economy to move to a 100 billion dollar level we need to ensure that we keep inflation at those levels.

"We would want to see interest rates in single digits again."

After growing around 8.0 percent for two years, Sri Lanka's economic growth estimated by the statistics office, is expected to slow this year to around 7 percent or less. Cabraal said Sri Lanka would return to the higher growth path.

"This year, as you would have seen, we have had to curtail growth to some extent to make necessary adjustments to bring stability and to maintain stability.

"But we would see that returning from next year, so that we can get back to 8.0 percent or 8.0 percent plus."
http://www.lbo.lk/fullstory.php?nid=612469516

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