(1) The demand and supply of money

For analytical and forecasting purposes, a key distinction must be drawn between monetary aggregates in real terms (constant prices) and in nominal terms (current prices).

The demand for money is formulated in real terms because economic agents hold money willingly in order to have purchasing power over goods and services. For instance, if prices all double and then stay at their new level, the public must hold exactly twice as much money, on average, to conduct a given amount of real transactions. Thus, while the demand for money should be thought of in real terms, the monetary authorities can affect only the nominal supply of money (the money supply process is discussed below in this section). If the monetary authorities supply more (less) than the private sector wishes to hold at a given price level, individuals will reduce (increase) their real money balances accordingly.

Box 7.1.

Stylized Monetary Survey

Assets			Liabilities
Net foreign assets			Money and quasi-money
	Of which:			Currency in circulation
		Net international reserves		Demand deposits
				Time and savings deposits
Domestic credit				Foreign currency deposits
	To government (net)			Other (less liquid) liabilities
	To public enterprises
	To nonbank financial institutions		Other items (net)
		institutions
	To nonfinancial private sector
		sector

View Table

Assets			Liabilities
Net foreign assets			Money and quasi-money
	Of which:			Currency in circulation
		Net international reserves		Demand deposits
				Time and savings deposits
Domestic credit				Foreign currency deposits
	To government (net)			Other (less liquid) liabilities
	To public enterprises
	To nonbank financial institutions		Other items (net)
		institutions
	To nonfinancial private sector
		sector

There are three principal mechanisms through which individuals affect real money balances:

• They may buy (sell) foreign currency in exchange for domestic currency in conjunction with balance of payments transactions—for instance, imports (exports) of goods and services and capital transactions. The stock of net domestic currency is reduced (increased) by the transaction, as is the stock of foreign assets held by the monetary authorities.

• They may buy (sell) goods in exchange for domestic currency. If individuals feel they have too much money relative to real goods, purchases will increase. This increase in the demand for goods in turn raises domestic prices. In effect, individuals reduce their stock of real money balances via inflation, although the nominal stock may remain the same.

• They may buy (sell) domestic financial assets other than money in exchange for domestic currency. The stock of domestic money balances then decreases (increases). The resulting rise (fall) in the prices of the nonmonetary financial assets leads to a decline (increase) in the yields, or interest rates, for these assets.

All these mechanisms can operate at the same time. If the monetary authorities supply too much (little) money, prices of domestic goods may increase (decrease), interest rates may decline (rise), and the balance of payments may worsen (improve). The more open the goods and capital markets are, and the less flexible the exchange rate system is, the larger the impact on the balance of payments will be.

For instance, in an economy with a fixed exchange rate and no exchange and trade controls, the authorities have little control over the nominal money stock. Any imbalance between the supply of and demand for money results in monetary expansion or contraction (through the balance of payments) and has a limited impact on prices. By contrast, in an economy with a fully flexible exchange rate and no exchange and trade controls, the exchange rate equilibrates the supply of and demand for foreign exchange, so that net foreign assets remain unchanged. In this case, monetary expansion permanently increases the nominal level of monetary aggregates; the counterpart of this increase is likely to be a jump in prices, including the price of foreign currency—that is, a depreciation of the exchange rate.

Increased spending resulting from monetary expansion may also raise real output, especially if there is underutilized capacity. Conversely, decreased spending may reduce output, especially if prices are downwardly inflexible. Taking the first case as an example, the increase in real output, by raising the number of transactions that need to be financed, should result in an increase in the demand for money. The output effect thus serves as an avenue for restoring equilibrium. It is generally accepted that the relationship between the growth of monetary aggregates and nominal output is positive, but the strength of this relationship and the impact of changes in the nominal money supply on prices and real output, respectively, are widely debated issues.

(2) Forecasting techniques

Since individuals determine the real value of their money holdings, the behavior of individuals must be taken into account in forecasting the real value of monetary aggregates. This section discusses two general methods of making these forecasts. One involves estimating a “demand for money” function based on regression techniques. The other approach is less formal and relies on trends in the velocity of money. The choice of methods is generally dictated by the availability of data and the stability over time of institutional arrangements and behavioral relations in a particular economy.

(3) The demand for money function

This method assumes that the financial behavior of economic agents can be explained as a function of a small number of economic variables. It also assumes that the relationship between monetary aggregates that are willingly held and the explanatory variables is stable over time.

The definition of money used for this estimate should be dictated by the empirical results. It is not possible to identify a priori the aggregate for which there is the most stable public demand. Generally, the larger the share of the banking system’s liabilities to the nongovernment sector included in the definition of money, the more helpful the definition is in forecasting the monetary survey. However, it may be more difficult for the monetary authorities to control a broadly defined monetary aggregate.

The explanatory variables in the most commonly used demand for money function are a transaction-related (scale) variable (most often real GDP) and an opportunity cost variable that measures the relative attractiveness of holding money.

The opportunity cost variable used depends to some extent on the definition of money that is selected and on the institutional arrangements of a country. In general, a representative nominal interest rate is the most appropriate measure of the opportunity cost of holding monetary assets that earn no interest (narrow money). For monetary assets that earn interest, a variable measuring the interest rate differential between money holdings and other financial assets may be more appropriate. In countries where the liabilities of the banking system to the private sector represent the greatest part of the latter’s total financial assets, the real interest rate has sometimes been used as a proxy for the yield on financial assets relative to real assets. In this case, the expected effect of the real interest rate on the demand for broad money is positive. Where interest rates remain unchanged for long periods or are negative in real terms, this effect may be better captured by the rate of inflation alone. In this case, the expected effect of inflation on real money holdings is negative.

The estimates of money demand in this workshop are based on the following simple specification of the money demand function.² For example:

where:

MO^d = the demand for the monetary aggregate;

P = a relevant price index;

Y = nominal GDP; and

Π = the opportunity cost of holding money.

An important assumption underlying equation 7.1 is that the demand for real money balances is always equal to the actual real supply. In fact, adjustments made in response to any disequilibria will require time to show results, reflecting factors such as the costs involved in eliminating a discrepancy between actual money holdings and the desired levels. A partial adjustment model is often used to account for such lags; it assumes that the adjustment in a given period corresponds to a fraction of the desired level of adjustment (ß).

Then, denoting MO^dand MO as the desired and actual amounts of the monetary aggregate in nominal terms, respectively:

where 0 ≤ ß ≤ 1. Combining equations 7.1 and 7.2 and rearranging the elements results in:

where:

b₁ = ßa₁;

b₂ = ßa₂;

b₃ = ßa₃;and

b₄ = 1-ß.

The values of the coefficients b₂, b₃ and b₄ can be estimated directly from the regression. These estimated values can then be used to derive the estimated values for a₂, a₃ and ß in equations 7.1 and 7.2.³

(4) The velocity of money

The velocity of monetary circulation (V) is defined as the number of times the money supply turns over in a given period to finance a certain level of economic activity. If the level of economic activity is approximated by a measure of income such as the nominal gross domestic product (which consists of real GDP, y, and the price level, P), the velocity of money can be represented by the following identity:

To interpret equation 7.4 behaviorally, recall that, in equilibrium, real money balances (MO/P) equal the demand for these balances. Changes in velocity thus track changes in the real demand for money.

For example, if the income elasticity of demand for nominal money balances is assumed to be one—that is, if an increase of a given percentage in nominal output raises the demand for money by an equal percentage—income changes have no effect on velocity. On the other hand, if increasing inflationary pressure causes the rate of return on real assets to exceed that on financial assets, the demand for money balances, at a given income level, can be expected to fall, resulting in an increase in velocity. Forecasts of the demand for real money balances made using this approach require analysts to use their own judgment in estimating velocity. Such estimates generally take into account recent or prospective behavioral or institutional changes that can affect transactors’ demand for money.

While quantifying the effects of such changes on the velocity of money is no doubt difficult, it is important at least to assess the direction of change. To the extent that the authorities underestimate velocity and therefore overestimate real money demand, the outcome is likely to be a higher inflation rate and/or a worse balance of payments position. At the same time, overestimating velocity can have the opposite effects. In this case, if there is downward rigidity in prices, the excess demand for money translates into lower output growth and higher unemployment. Thus, the choice of a velocity assumption in a financial program also depends on the relative importance of the inflation target compared with the output and employment targets.

(1) Net foreign assets

Projections of net foreign assets are directly linked to the prospects for the overall balance of payments. In a normative scenario, net foreign assets are typically not seen as a passive outcome of existing policies but instead are targeted. Abstracting from data and valuation problems, the change in net foreign assets of the banking system should be equal to the change in net official international reserves and other foreign assets held by the banking system that are not included in the definition of reserves, minus the change in the banking system’s foreign liabilities.

(2) Domestic credit

Once projections for real GDP, prices, and net foreign assets have been determined and estimates of the monetary aggregates made (based on the expected behavior of the public), the amount of domestic credit is calculated as a residual (given some reasonable assumption with respect to the change in other items). This result follows from the monetary survey identity. The amount of domestic credit calculated should be consistent with developments in the other sectors of the economy; that is, the behavioral relationships among key economic variables should hold, so that growth in credit is consistent with projected investment and output. Otherwise, a further iteration of the economic forecast across sectors will be required.

The distribution of credit among the government, state enterprises, nonbank financial institutions, and the private sector is a function of policy priorities. For example, in a scenario where government policies are taken as given, the amount of net credit extended to the government is usually dictated by the existing budgetary position in relation to the cost and availability of external and nonbank financing. The credit requirements of the nongovernment sector can be accommodated more fully if the budgetary position is adjusted through revenue-raising and expenditure-reducing measures.

(3) Other items (net)

Other items (net), by its nature, is a difficult variable to forecast. Factors that heavily influence the movements of this variable include increases in the share capital of banks made, for example, to meet capital adequacy requirements, valuation changes of the net foreign asset position, and profits and losses of the banking system.

For example, a depreciation of the domestic currency vis-à-vis other currencies raises the level of the banking system’s net external indebtedness, measured in local currency. Assuming no new net flows of foreign exchange, there should be no effect on the level of monetary aggregates, only an offsetting valuation adjustment entry included in other items (with a positive sign if the foreign position is a liability). Undistributed profits of the banking system are recorded in other items (net) with a negative sign, the counterpart entry being a decline in monetary aggregates.

(1) Background

The financial system in Sri Lanka at the end of 1990 was relatively developed and diverse. Along with the Central Bank of Sri Lanka, the banking system comprised 23 commercial banks, 22 foreign currency banking units, the State Mortgage Investment Bank, the National Savings Bank, 12 recently formed regional rural development banks, 3 merchant banks, and 2 development finance institutions. There were also 3 leasing and 22 finance companies, although the number of finance companies decreased considerably during the late 1980s following a near-crisis in the sector. Long-term financial resources were (and still are) mobilized mainly by the two largest pension funds—the Employees’ Provident Fund and the Employees’ Trust Fund—and five insurance companies. In the capital market, activity in the Colombo Stock Exchange has increased in recent years, and three unit trusts have been established. Although the Central Bank and the commercial banks have remained the predominant institutions, other financial institutions have gained an increasing share of total gross assets since 1987.

The Central Bank, established by the Monetary Law Act of 1949, acts as bank of issue, lender of last resort to the banking system, and banker to the government. (The Act limits advances to the government to 10 percent of government revenues, although Treasury bills are considered outside this ceiling.) The Central Bank also regulates and supervises financial institutions and actively supports rural economic development through both its refinancing facilities and its sponsorship of regional rural development banks.

Of the 23 commercial banks operating in Sri Lanka, 2 are state owned. Four of the private banks are domestically owned and 17 foreign owned. The two state-owned banks, the Bank of Ceylon and the People’s Bank, dominate the sector, accounting for nearly two-thirds of the banking system’s total assets. These banks act as market leaders in determining interest rates and have maintained a fairly stable market share that reflects certain competitive advantages over the privately owned banks, including their large network of branch offices and an implicit government guarantee on deposits. These banks have also been the major source of credit to public enterprises and have acted as a financial conduit for many government development schemes. Their interest margin is almost double that of the state banks of other countries in the region, the result of lending policies not oriented toward commercial objectives, the large proportion of nonperforming assets in the banks’ portfolios, and inefficiencies that have led to relatively high administrative and labor costs. As the more efficient foreign banks have not yet become competitive enough to close the margin and the more aggressive private local banks have only recently been established, borrowers in all institutions continue to bear the increased costs of financial intermediation by these two banks. (The costs of intermediation still averaged about 8 percent during 1989-90.) Business failures arising from the disruption of economic activity in 1989 have also rendered debt recovery more difficult. However, debt recovery legislation was enacted in 1990 allowing lending banks to seize collateral without prior approval by courts.

The sharp expansion of private domestic banks since 1987 can be attributed to the opening of two new local banks and the expansion of the banking network to 28 branches. While there are no special regulations pertaining to foreign banks except for licensing, the government imposed an embargo on additional branches until 1989. Since 1989, foreign banks have been reluctant to expand operations, possibly reflecting caution in light of the security situation. Although foreign banks have a relatively small branch network (4 percent of the system) and are located primarily in the Colombo area, they still attract more than 18 percent of total deposits.

The foreign currency banking units (FCBUs), which administer the offshore banking activities of the commercial banks, were originally established in 1979 to provide financial facilities for enterprises located within the free trade zones. In addition, several large public enterprises were granted special permission to obtain foreign currency credit from these banks, primarily for short-term, trade-related purposes. The credit they extend is not monitored within the monetary survey, nor are they regulated or supervised by the Central Bank. In 1990, credit extended by FCBUs as a proportion of banking system credit was about 9 percent, a sharp rise from about 4 percent in 1988.

The Central Bank supports a number of activities through its refinancing facilities and guarantees. First, it aims to promote a rural development scheme involving the regional rural development banks, which commenced operations in 1985 under the sponsorship of the Central Bank, mainly to provide agricultural credit in small rural villages outside the framework of formal financial institutions. While the rural banks mobilize some time deposits, they rely heavily on the Central Bank for refinancing and borrowing. Second, the Central Bank supports a government restructuring scheme for finance companies established in the wake of a crisis in the sector in 1988. Under this scheme, two finance companies have received large amounts of medium- and long-term refinancing.⁴ Third, the Central Bank provides refinancing for central government activities. And fourth, it has provided refinancing for ad hoc purposes: for instance, in 1990 a special facility was extended for a food buffer stock.

The development finance institutions and the State Mortgage Investment Bank are the principal sources of long-term lending in Sri Lanka, but a substantial proportion of long-term financing is provided by external sources. The privately owned National Development Bank and the Development Finance Corporation of Ceylon provide more than two-thirds of industrial lending, utilizing foreign exchange funds from donor agencies. Both of these institutions have experienced strong growth since 1987 (over 30 percent per year); however, further growth may be hindered by the limited availability of long-term local currency resources. The State Mortgage Investment Bank (which makes long-term fixed-interest housing loans) accounts for only about 1 percent of total financial assets in Sri Lanka but provides about 60 percent of the housing mortgages. It depends on one-year and five-year fixed deposits and must compete with Treasury bill yields to raise the requisite funds.

The financing of the government budget places heavy demands on the resources of institutions with long-term funds to invest. The two largest pension funds—the mandatory retirement plans for most of the nation’s employees—hold about 15 percent of Sri Lanka’s financial assets. A government directive requires that about 90 percent of their funds be invested in government securities. Similarly, most of Sri Lanka’s five insurance companies (three private, two state owned) invest in short-term government securities and fixed-term deposits at the commercial banks. The National Savings Bank, which raises money through deposits and postal savings accounts, channels its resources into government securities.

Currently, the Central Bank supervises only commercial banks and finance companies. The Banking Act and the Finance Companies Act of 1988 specify a number of prudential regulations relating to minimum capital and liquidity requirements and loan exposure limits. The Central Bank issued several further directives in 1989 limiting the shares banks can hold and banks’ exposure to large borrowers. A credit information bureau was established in July 1990 to provide financial institutions with information on large borrowers that may be in default. A voluntary deposit insurance scheme was also established, but at the end of 1990 only three small private banks were paying the quarterly premium of 0.04 percent of deposit liabilities required to participate, as deposits at the state financial institutions are covered by an implicit government guarantee.

(2) Monetary policy instruments and money and capital markets

Since the late 1980s, the Central Bank’s main monetary policy instruments have been the reserve requirement, refinancing facilities, and, to a lesser extent, selective credit controls and the bank rate. More recently, administrative changes aimed at increasing the efficiency of open-market operations in Treasury bills have been the principal means of affecting domestic liquidity growth.

As it is presently defined, the reserve requirement can be satisfied with Treasury bills but not vault cash. To the extent that commercial banks are required to hold Treasury bills at below-market interest rates in order to satisfy their reserve requirement, the profitability of financial intermediation is adversely affected—unless the impact is passed on to depositors or borrowers. In any case, the requirement as it stands discourages the development of financial intermediation, distorts the structure of interest rates, and constrains the liquidity of commercial banks to the extent that liquid assets are given up for less liquid Treasury bills. Ultimately, it could affect monetary management by allowing the banking system little room to maneuver with respect to financing the fiscal deficit. The Central Bank’s position in terms of the discount window also distorts interest rates and leads to an uneven playing field, as the Bank operates a range of preferential refinancing facilities with rates ranging from 1.5 percent to 11 percent.

Interest rate policies in Sri Lanka are relatively liberal, and commercial banks are permitted to determine their own deposit and lending rates. However, a number of distortions have affected the levels and structure of interest rates. With respect to lending rates, the two dominant state-owned commercial banks tend to be market leaders. In addition, lending rates for some policy-related programs—such as small agriculture and rural development self-employment schemes—do not always adequately reflect the risk involved. For deposit rates, the National Savings Bank, which holds almost one-fourth of all deposits, has traditionally been the price leader in commercial bank rates. This bank has an advantage in attracting deposits, as interest income on its deposits is tax exempt. Since most of its assets are in low-yielding government securities, the bank’s financial position has been supported by transfers from the budget.

Despite an increased emphasis on indirect monetary control, the government’s reliance on instruments of direct control, such as selective credit, has continued. In June 1989, the Central Bank froze commercial bank credit to certain nonpriority sectors at its end-May level and imposed a 100 percent deposit margin against letters of credit for imports of luxury and semiluxury goods. At the start of this policy, 30-40 percent of bank credit was covered; credit to agriculture, exports, and industry was exempted. These measures were still in effect at the end of 1990.