Central Bank to embark on bold reforms on monetary policy implementation efforts

• CBSL cuts the number of policy meetings to six from eight
• Set to review banks’ SRR in line with best practices & optimise its use as a monetary policy tool
• Considers removing restrictions on the access to standing facility window

The Central Bank announced this week a slew of changes to its monetary policymaking to improve both its efficacy and transmission, as it remains committed to maintaining price stability under the inflation targeting framework while facilitating the economy to reach its full potential.

In addition to the consideration of moving towards a single policy rate structure from the current dual policy interest rates, the Central Bank said it would cut the number of monetary policy meetings to six from eight this year. This is in line with the new Central Bank Act. The move will give the members more time to assess the data and make better-informed policy decisions.
As a result, the Monetary Policy Board, as it is now called under the new Act, would meet once every two months to determine the trajectory of the interest rates. The first such meeting for the year is scheduled for January 22.

The Central Bank also announced its intentions to review the existing framework of the banks’ statutory reserve requirement in line with international best practices. 

This is done to enhance flexibility for licensed commercial banks in managing reserves and supporting the payment system. It will also pave the way to optimise the usage of the statutory reserve ratio as a monetary policy tool.

The statutory reserve requirement is the mandatory minimum amount of deposits the licensed commercial banks must maintain as liquid assets in government securities.
Currently, the minimum requirement stands at 20 percent of the deposits. Banks at present operate with substantially higher reserve amounts than the regulatory minimum. The reason being, that they have parked large sums of deposits in treasury bills and bonds during the last two years. This was done when the yields of banks shot up to over 30 percent, earning them easy money compared to giving them as loans to customers. The latter comes with a heavy risk.

During the domestic debt optimisation programme last year, the Central Bank left out the banks from the need to restructure the bills and bonds they hold in their books, considering the ripple effects such an exercise could send through the broader economy.

Meanwhile, the Central Bank announced it would consider removing the existing restrictions on banks to access the standing lending facility window as the money market activity shows improvement.

The Central Bank a year ago restricted access by the licensed commercial banks of the standing lending facility for their liquidity deficits to five times a month in a bid to reactivate the money market and compel them to transact among themselves between units with excess liquidity and deficit units.

The financial sector regulator said the over-reliance by these participating institutions on the Central Bank facilities had been a challenge for monetary policy implementation.
Going a step further, the Central Bank will also start exploring alternative mechanisms for the standalone primary dealers to reduce their over-dependence on the Central Bank in line with the global best practices.

To begin balance sheet run-off, end new monetary financing

The Central Bank announced this week the initiation of a balance sheet run-off. This move comes as the institution addresses the unprecedentedly substantial expansion of its balance sheet in the recent past. While the Central Bank would end its monetary financing, or the money printing as referred to in common parlance, it would also start gradually unwinding its outstanding bills and bonds stock held in its balance sheet, perhaps causing some tightening in the monetary conditions.

“The cessation of monetary financing under the CBA, the anchoring of inflation expectations, and the reduction of risk premium on government securities are expected to have a favourable impact over the medium term on the transmission of monetary policy actions by the Central Bank”, the financial sector regulator said in its latest annual policy statement.
The Central Bank emphasised that in the upcoming period, there will be a reduction of the outstanding stock of monetary financing. This process will be executed in accordance with the provisions outlined in the Central Bank Act through the implementation of monetary policy measures.

From the onset of the pandemic in 2020, the Central Bank started providing an unprecedented level of support to the economy by way of Central Bank liquidity which is created by way of purchasing the treasury bills and bonds issued by the government.

While the practice wasn’t anything different from what any Central Bank in the world did during the pandemic by providing liquidity to the markets and also supporting hundreds of thousands of individuals and businesses to backstop them from defaulting and running out of money, some started calling this out as the root cause for the bout of runaway inflation caused during 2022 and part of 2023.

The sell-down or the unwinding of this stock might cause the opposite effect to the current easing policy stance by tightening financial conditions, somewhat offsetting the effects of the easing monetary policy.

The Central Bank had Rs.78.21 billion worth of assets at its face value on March 1, 2020, when the country entered into pandemic-induced shut-downs and broad-based disruptions to the economy for nearly two years.

This has expanded to Rs.2,753.62 billion, although the Central Bank has been practicing much restraint on any more asset purchases since April 2022. All these assets however do not end up as currency or printed money. Even according to the programme targets set by the International Monetary Fund (IMF), the Central Bank could not carry over Rs.2.8 trillion worth of assets in its balance sheet. This has necessitated the unwinding of the balance sheet by the Central Bank while requiring the Treasury to maintain a cash buffer to prevent the need for monetary financing.