Courtesy Ceylon Today

Let me start by congratulating the Governor, Deputy Governors, members of the former Monetary Board and members of the current Monetary Policy Board. Since April 2022 they have taken bold decisions and led the demanding technical work to stabilise the economy after the deepest economic crisis that Sri Lanka has suffered since independence. It is easy perhaps to take for granted the progress so far. But let us not forget that barely 20 months ago, Sri Lanka’s inflation rate was unanchored, the exchange rate was depreciating uncontrollably, foreign reserves were depleted, and the economy was collapsing with shortages of food, fuel, and essential medicine. Declaring an orderly foreign currency debt moratorium, raising interest rates sharply, and curtailing the monetisation of fiscal deficits were essential first steps to stabilise the economy and avoid a disorderly default. It is no mean feat to have brought inflation down from a peak of almost 74 per cent last September to less than 2 per cent a year later, over-performing the IMF’s projections. To have accomplished this while maintaining financial stability is all the more impressive given the deep economic contraction that, together with the preceding pandemic, has weakened financial sector balance sheets. Monetary policy was also responsive in lowering the policy rate when clear evidence emerged that monthly inflation was stabilising. Let me say, based on my years of experience at the IMF working with countries around the world, often during economic stress, that these are by any standard impressive accomplishments. Without skilled leadership and decision-making, it could very easily have been much worse.

These monetary policy actions were successful also because of the support from the Government’s fiscal policies and the leeway given to the CBSL to conduct monetary policy according to its best judgment. Tax cuts during the previous government had reduced our tax ratio from almost 11 per cent of GDP in 2019 to a mere 7.5 per cent of GDP on average in 2020-21, one of the lowest in the world—lower even than the tax ratios of very poor countries like the Central African Republic and Burkina Faso. With interest payments taking up 73 per cent of government revenue and an overall fiscal deficit of almost 12 per cent of GDP on average in 2020-21, the fiscal position was simply not sustainable. The Government took decisive and necessary action to increase tax rates, bolster tax collections, and implement cost-recovery pricing in energy. It has tightened spending to generate the needed improvement in the primary fiscal balance in line with the IMF-supported programme. These were difficult decisions and politically unpopular. But they were necessary.

Unfortunately, the ship that is the national economy cannot be turned around quickly. So people tend to blame the corrective policies and the policymakers who are doing the right thing, rather than the reckless policies of the past that are the fundamental cause. Such is the unenviable position of policymakers who step in to rescue their countries from crises. You have my sympathies!

So what now? Significant progress has been achieved but we are in a low-level equilibrium with output well below potential. This crisis is not yet over. The only way out is to grow, at a rate of about 5-6 per cent a year, in a sustainable, inclusive way. Without such growth, we cannot escape our high debt burden even after a successful restructuring. And because the debt burden lies with the public sector, the public sector will need to contract not just this year, but also in the decade ahead. So growth will need to come from the private sector and be export-oriented given our foreign exchange needs. There is simply no other option.

Much remains to be done to get the economy on such a dynamic growth trajectory. Nor should we take for granted, having achieved low inflation, that inflation will always stay within the CBSL’s target of 5 per cent or that progress in the fiscal area will continue. Our post-independence economic history is full of stop-and-go policies and brief victories over instability that are not sustained. We cannot afford yet another replay of that familiar script.

Why not? Well, this time really is different for three reasons:

– First, in all our previous bouts of macroeconomic instability, our public debt ratios have stayed below 80 per cent of GDP, tax revenues have never been as low as they were in 2020-21 and we had never defaulted on our debt. According to the IMF’s Debt Sustainability Analysis, even if we successfully restructure our debt and adhere to tight policies that generate primary fiscal surpluses of 2.3 per cent of GDP from 2025 to at least 2032, our public debt will decline to only about 95 per cent of GDP by 2032. To put this debt level in perspective, in 2022, government debt to GDP averaged 65 per cent in emerging and developing economies and—looking at our neighbors—55 per cent in India; 40 per cent in Indonesia; and 54 per cent in Thailand. So unlike in the past where we muddled through with debt to GDP ratios around 60-80 per cent, the baseline debt ratio will now be much higher. We will beat a high risk of debt distress even after a successful debt restructuring. If we become complacent and go slow on reforms, we can easily be back in a crisis where we are unable to pay our debts. Except next time, the adjustment will be far more painful because we would have already restructured domestic and external debt. More of the adjustment therefore will fall on our citizens and less on external creditors. This point needs to be widely understood.

– The second reason this time is different in that many people are now in poverty or very close to poverty and have little or no cushion left. The World Bank estimates that the poverty rate doubled to 25 per cent of the population in 2022 while the UNDP estimates that over half the population remains ‘multi -dimensionally vulnerable.’ The World Food Programme finds that almost a third of children under five are malnourished with 20 per cent suffering from wasting. Nearly two-thirds of the population are borrowing or dipping into their savings to feed their families. Many people are foregoing basic needs such as healthcare, and progress in education has been severely hampered by both the pandemic and the economic crisis. The impact on people of another debt default, crisis, and adjustment would be disastrous and raises the likelihood of social unrest.

– And third, Sri Lanka is suffering from a damaging outflow of skilled professionals who are the backbone of economic recovery and growth. These professionals are not leaving merely because of taxes as is often said. They have lost hope that the poor governance and pervasive corruption that Sri Lanka has been mired in for decades will be effectively addressed. They don’t see a future in a country where the state interferes with practically every aspect of economic life, and politicians and public officials who engage in gross corruption are never punished. Another crisis will turn this outflow into an exodus.

The empirical evidence clearly shows that crises cause permanent losses, both in terms of GDP and human welfare. Countries that undergo multiple crises—think Argentina—stagnate compared with countries that have steady growth over prolonged periods. Boom-bust cycles leave countries worse off. We should not try to get out of our current low-level equilibrium through fiscal policies that give a short-term boost but will land us in another debt crisis a few years down the road. We will also be vulnerable for many years to exogenous shocks, such as a rise in global food and energy prices, particularly from the ongoing wars in Ukraine and the Middle East; higher world interest rates; a poor agricultural harvest; or a natural disaster. In addition, we will need to invest considerable resources in adapting to climate change and preserving biodiversity. We are on a knife edge, and there is simply no room for slacking off or policy reversals. But, with focus and effort, we can set ourselves on a road to sustained growth and inclusive prosperity.

So what is the way forward? How can we avoid repeating our history of inconsistent, stop-and-go policymaking? We have discussed for years what is needed for sustained growth—fiscal discipline, an open trade regime that encourages exports, competitive markets, modernised labour laws, and adequate infrastructure such as efficient electricity, transport, and ports. It’s no mystery, so why don’t these things get done?

I believe that our fundamental problem is poor governance and that, unless we address governance problems head-on, we will never durably overcome our economic problems and prosper. My thesis today is that when we discuss economic policies, we should focus more squarely on the governance around those policies and not only on the policies themselves.

So what do we mean by ‘good governance’?

There is no standard definition, but people know bad governance when they see it. Certainly, not a day goes by in Sri Lanka without the newspapers reporting some instance of bad governance.

Let me, for today’s purposes, use the definition by UNESCAP. They define governance as [quote] the process of decision-making and the process by which decisions are implemented”. And the principles of good governance include accountability, transparency, adherence to the rule of law, responsiveness, effectiveness, and efficiency.

My point today is that we need to be more explicit not just about economic policies—for instance, whether an interest rate or a tax rate should be raised or lowered or a particular public enterprise privatised or not. We also need to be explicit about the process by which those policies are decided and implemented. It is very likely that if we improve the process—that is, we make policymaking and implementation more accountable, transparent, adhere to the rule of law and so on—the resulting policies will improve as well. It is also likely that if we have good policymaking processes and strong institutions, good policies will continue even if the politics turn difficult.

I do want to acknowledge that getting to good governance is no simple task. It requires sustained social pressure and political will to take on the vested interests that are served by poor governance. People sometimes complain that nothing works in Sri Lanka. That’s not quite true. Actually, things work very well—for a small group of people. The challenge, if we are to avoid repeating the mistakes of the past, is to ensure that our policymaking and implementation processes and institutions obey the principles of good governance so that policies serve the interests not just of a small group, but of all members of society.

Three policy objectives

I would like to focus today on good governance for three policy objectives that are—in my view—the most important to get us out of this crisis and lay the basis for inclusive prosperity.

– First, maintaining durable price stability through sound monetary policy

– Second, achieving fiscal sustainability through better taxation

– Third, enabling market-oriented growth by reducing the size and role of the public sector.

For the last two—mainly fiscal—topics, I draw extensively on three sources published in September: the IMF’s Governance Diagnostic Assessment of Sri Lanka—or GDA for short; Sri Lanka Civil Society’s Governance Diagnostic Report; and the World Bank’s Country Update on Sri Lanka. These reports are based on thorough research; extensive interviews with officials and other stakeholders; and written or guided by experts with international experience in their respective fields.

Since this occasion marks the 73rd anniversary of the CBSL, let me start with strengthening the governance to maintain durable price stability through sound monetary policy.

The economics literature and central banking practice have convincingly established for decades the need for central bank independence and a sound monetary policy decision-making process to achieve low and stable inflation. Most major countries’ laws safeguard central bank independence and aim to insulate monetary policy from political interference. Indeed, one of the oldest such laws, the US Federal Reserve Act of 1913 recognises this need explicitly. It specifies, to that end, that the Federal Reserve may buy and sell US Treasury securities only in the open” or secondary market. It was recognised then—over a hundred years ago—as it is now, that direct financing of the Government would leave decisions over monetary policy open to political interference and undermine the goal of low inflation while creating risks to economic and financial stability.

This year’s passage of the Central Bank of Sri Lanka Act is a very significant milestone on the path to achieving good governance in the conduct of monetary policy. The Act explicitly recognises the CBSL’s independence. There is now a clear mandate that price stability is the primary objective of the CBSL with financial stability as a secondary objective. Inflation-targeting with a flexible exchange rate is established as the monetary policy regime. A critical feature is that there are no longer any government officials in the monetary policy decision-making body—the Monetary Policy Board—nor on the Governing Board, which oversees everything else. There is also an appropriate balancing of central bank independence with accountability and transparency. The inflation objective is specified by the Minister of Finance, who would be an elected representative. The Monetary Policy Board is accountable to Parliament through the Minister to deliver on the inflation objective and provide a public explanation if inflation falls outside the agreed range for two consecutive quarters. The Board is also mandated to issue a public statement after each policy meeting to explain the monetary policy decision in the context of economic developments and forecasts. In addition, the CBSL has to issue a public inflation report every six months, explaining its inflation projection and key risks to the projection. Contrary to the concerns that emerged during the parliamentary debate, these features of the law provide for much greater accountability than in the past. The operational independence that the central bank has been given to achieve the target assigned to it should not be confused with being unaccountable. Quite the opposite.

The strong legal framework is a necessary, but not sufficient, condition for sound monetary policy. Legislation must be reinforced by practice and the creation of a strong culture. An important responsibility for the newly-constituted Boards—the distinguished members of which are here today—will be to create the practice and culture of good governance under the new legal framework. In particular, given Sri Lanka’s past, it will be important to ensure that the Monetary Policy Board takes policy decisions on solid technical grounds with a clear focus on the price stability mandate. The technical grounds would be based on the CBSL staff’s economic modelling and analyses combined with the Board’s collective judgment on the likely evolution of inflation. Insulating the conduct of monetary policy from fiscal and political pressures will be the hallmark of a good decision-making process—especially in the upcoming election year. And this is not only the responsibility of the CBSL. Everyone, including political actors, will need to create a culture of respecting the CBSL’s operational independence and the integrity of its decision-making. Central Bank independence needs to be supported by our social and political culture.

The newly-independent CBSL will also need to promote a culture of transparency. The new Law includes key features such as post-meeting public statements, regular inflation reports, statements in anticipation of significant shocks, and answering to parliament. While many central banks publish inflation reports and post-meeting statements, they are not all equally illuminating. Some statements are anodyne and avoid addressing substantive issues the decision-making body grappled with. Others, such as those by the Nordic central banks, the Bank of England, and the Fed inform the public about the substance of the issues the policy committee discussed. They give a sense not only of the balance of risks to inflation, but also of how the committee sees the likely stance of its policy rate looking forward. Transparency is a ‘must have’—not simply a ‘nice to have’—in an inflation-targeting regime. Clear explanations of how the Monetary Policy Board sees inflation risks and how its actions will keep future inflation within the target range are needed to anchor inflation expectations of financial markets and the public so that actual inflation stays within the target range. Transparent communication may initially be met with confusion and misinterpretation. But over time, both financial markets and the public will learn how the Monetary Policy Board assesses inflation risks and how it is likely to react to shocks. This will help the CBSL keep inflation within its target range even when the economy is subjected to significant shocks.

(To be continued)