VII. Monetary Sector
  • 1 0000000404811396 Monetary Fund
  • | 2 0000000404811396 Monetary Fund


Monetary aggregates play an important role in the determination of real output, prices, and the balance of payments, all of which are indicators of some of the final objectives of economic policy.1 The forecasting of monetary aggregates is thus a key step in the design of monetary policy.

1. Forecasting Monetary Aggregates

a. Introduction

Monetary aggregates play an important role in the determination of real output, prices, and the balance of payments, all of which are indicators of some of the final objectives of economic policy.1 The forecasting of monetary aggregates is thus a key step in the design of monetary policy.

In formulating monetary policy, the authorities must ultimately keep in mind the relationship between the monetary instruments under their control and the final policy objectives. However, these relationships are typically indirect and have two components: (i) the link between intermediate targets (monetary aggregates) and final objectives; and (ii) the connection between policy instruments and intermediate targets. A third element is sometimes added: the relationship between intermediate targets and operating targets (those variables the monetary authorities can influence or control directly).

The monetary survey is a consolidation of the balance sheets of the different components of the banking system—that is, the sum of transactions of the Central Bank and commercial banks, netting out all interbank transactions. It provides a framework for analyzing the desired values for those variables, such as broad money, for which the authorities can set intermediate targets. Broad money represents the counterpart of, and by definition must be equal to, the sum of net foreign assets (valued in local currency) and domestic credit, net of other items (Box 7.1).

b. Projections of monetary aggregates

(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.

Stylized Monetary Survey

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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:



MOd = 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 MOdand 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:



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.

c. Forecasting other components of the monetary survey

(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.

d. Forecasting the accounts of the monetary authorities

A typical balance sheet of the monetary authorities is shown in Box 7.2. The domestic liabilities of the monetary authorities are referred to as reserve money (also known as the monetary base or high-powered money). Reserve money is defined as the sum of all currency in circulation outside banks plus banks’ cash and deposits at the central bank. Variations in reserve money (R) reflect changes in the asset side of the balance sheet of the monetary authorities, which is composed of net foreign assets (NFA)*, claims on the government (NDCG)*, claims on commercial banks (DCB)*and on other financial institutions (DCF)*, and other items, net (OIN)*. For example, an overall surplus (deficit) in the balance of payments adds to (subtracts from) the net foreign assets of the monetary authorities and, given domestic assets and other net liabilities, increases (decreases) reserve money. Similarly, when the central bank brings about a net increase (decrease) in its assets by buying (selling) government securities or making (calling in) loans to (from) commercial banks, the increase (decrease) in these assets is typically accompanied by an increase (decrease) in reserve money.

Stylized Balance Sheet of the Monetary Authorities

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The central bank’s control over reserve money is incomplete. For example, changes in net foreign assets, which are a reflection of the balance of payments outcome, cannot generally be considered a policy-controlled variable. Variations in net claims on the government are, in many countries, adjusted passively to the government’s budgetary position, although clearly in countries where the central bank and the fiscal authorities coordinate their policies, this variable can be controlled. Typically, the most controllable factor is claims on commercial banks.

The behavior of the monetary aggregates of the consolidated banking system, as reflected in the monetary survey, can be linked to the behavior of the monetary authorities’ reserve money by the following equation:



MO = money, however defined, of the monetary survey; and

k = money multiplier.

If the monetary aggregate of interest in the consolidated banking system is broad money (M2), then the multiplier is derived as follows:



CY = currency outside banks;

DD = demand deposits;

TD = time and savings deposits;

rd = required reserve ratio against demand deposits;

rt = required reserve ratio against time and savings deposits; and

re = excess reserves as a ratio of demand deposits.

Dividing the numerator and denominator by DD and defining c and b as the ratios of currency outside banks and of time and savings deposits, respectively, to demand deposits results in:


Equation 7.7 indicates that the value of the money multiplier reflects the behavior of three different types of economic agents: (i) the monetary authorities setting the reserve requirements; (ii) the general public that, given the structure of interest rates and other variables, determines the composition of the money stock (the amount of currency held relative to deposits); and (iii) the commercial banks, which decide how much to hold in excess reserves.

2. The Monetary Sector in Sri Lanka

a. The financial structure and recent monetary developments in Sri Lanka

(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.

(a) The primary Treasury bill market

Since late 1986, Treasury bills have been issued to the public in Sri Lanka through weekly tenders. The amounts offered in the weekly auctions are determined by a committee and are based on projections of maturing bills and the anticipated demand for new bills. All sales of Treasury bills to entities other than the Central Bank are made on a competitive basis during these auctions. The Central Bank influences interest rates by setting a cutoff price (the highest yield at which a bid is accepted), beyond which all bills tendered are absorbed by the Central Bank at the average yield of those tendered on a competitive basis. Net sales of Treasury bills at the primary auction have become the prime vehicle for influencing the growth of reserve money and have also served to enhance the role of market forces in determining interest rates.

Historically, most issues of Treasury bills have been bought up by the Central Bank. However, in recent years, and especially since the development of the weekly auction, the share of Treasury bills held outside the Central Bank has been increasing. In 1989, in a move to absorb excess liquidity, the authorities allowed Treasury bill interest rates to rise in order to encourage holdings of Treasury bills outside the Central Bank. These holdings did indeed increase, encouraged by the weekly auctions; by the end of 1989, they accounted for nearly one-third of all Treasury bill holdings. The proportion of Treasury bills held in the nonbank sector also increased, rising from 14 percent at the end of 1987 to 23 percent in the middle of 1989. Government corporations are the primary purchasers in this sector.

(b) The secondary Treasury bill market

The Central Bank buys and sells short-term Treasury bills at its secondary window. Both buying (rediscounting) and selling prices are set in relation to the weighted average rate in the most recent primary auction. In January 1987, the Central Bank imposed a penalty of about 4 percent per annum on Treasury bills sold through the secondary window in order to channel demand to the primary auction. Starting in October 1987, the Central Bank imposed a penalty on purchases of Treasury bills (rediscounting) through the secondary window. This penalty was eliminated in early 1988 but was reimposed in September 1988 at about 5 percent per annum.

(c) Central Bank securities

Central Bank securities were introduced to absorb excess liquidity before the Treasury bill auction became the primary vehicle for open market operations. In January 1987, the Central Bank stopped conducting monthly auctions of six-month Central Bank securities, and these securities are now rarely used. The last issues were small ones in March 1987 and the first half of 1988.

(d) The interbank market

The interbank market is a thin and volatile market in unsecured transactions, mostly at call. The lack of a term structure has inhibited its development and prevents institutions from depending on it. In 1988, the average exposure of all banks was the equivalent of about 1 percent of deposit liabilities. Two factors explain the low volume: the fact that all the banks are fairly liquid, and the availability of Central Bank refinancing for many transactions.

The market is supplied mainly by the two large state banks and the National Savings Bank, but these institutions have self-imposed limits on lending to this market. When either of the two large commercial banks comes into the market for funds (often to cover large payments for petroleum or food imports), strong temporary upward pressure on interest rates results.

(e) Long-term government securities

Rupee securities with a maturity of more than one year have traditionally been used as a captive source (that is, sold to the National Savings Bank) to finance the government’s budget deficit. For budgetary reasons, these securities have always carried below-market yields.

b. Money and credit developments: 1988-90

The rapid credit expansion of 1988 was reflected in the growth of broad money, which rose by 17 percent by the end of the year (narrow money growth accelerated to 29 percent), and a loss of net foreign assets. Domestic credit accelerated to 29 percent, largely because of the public sector’s ongoing need for financing, and bank credit to the government rose by 34 percent. Credit to public corporations also increased sharply (46 percent), reflecting both the difficulties of financing a large wage increase in the public sector and growing civil disturbances. Similarly, private sector credit grew rapidly (by 22 percent). Even though liquidity in the banking system increased, interest rates rose, reflecting a rise in inflationary expectations. Despite some efforts to tighten monetary policy, reserve money growth accelerated to 26 percent in 1988 owing to the sharp jump in the Central Bank’s net domestic assets, the result of heavy government borrowing.

In 1988, the Central Bank implemented a number of measures to restrain monetary growth, including open market operations and increases in reserve requirements. Treasury bill rates were allowed to rise from 11 percent to 19 percent during the year, and a limited number of Central Bank securities were issued. The statutory reserve requirement of commercial banks was increased by 3 percentage points (to 13 percent of total deposit liabilities) in February 1988 and by another 2 percentage points (to 15 percent) in September 1988. However, since all of this increase could be held in the form of Treasury bills, the measure did little to reduce monetary growth. Instead, it served to shift the composition of bank credit from the private sector to the government.

The effect of these restrictive measures was diminished by several equally expansionary measures implemented in response to emergencies, including the crisis in the finance companies sector (described below in this section); an additional refinancing facility for exporters adversely affected by civil disturbances; and temporary accommodation to some banks affected by these disturbances.

In the first half of 1989, continuing large budgetary expenditures resulted in heavy borrowing from the banking system, particularly from the Central Bank, and bank credit to public enterprises also increased rapidly. Given the low level of domestic confidence, the effect was reflected largely in a decline in international reserves. To avoid a continued sharp loss in external reserves and rebounding inflation, in August 1989, the authorities adopted a package of measures to slow down the growth in money and credit.5 The Central Bank pursued this objective primarily through intensified sales of Treasury bills to the nonbank sector to absorb excess liquidity. Yields on Treasury bills at the primary auction were maintained at 19 percent, and a number of supporting measures were adopted, including an upward adjustment of bank rates from 10 percent to 14 percent; the introduction of a 100 percent margin deposit requirement against letters of credit for specified luxury and semiluxury imports; and the reimposition of partial ceilings on commercial bank credit to nonpriority sectors, which covered almost one-half of total bank credit. At the same time, following a gradual depreciation of the exchange rate over a period of several months, the authorities declared their intention to prevent any further nominal depreciation for an unspecified period.

As a result of these efforts, broad money grew by only 11.3 percent in 1989, down sharply from 16.6 percent in the previous year. A marked slowdown also took place in 1989, with the annual growth of broad money falling from 13.6 percent in the first quarter to 9.5 percent in the fourth quarter and reserve money declining from 18.3 percent to 4.8 percent over the corresponding period. Growth in total domestic credit slowed sharply to only 5 percent from 29 percent in 1988. The largest change occurred vis-à-vis the government sector, which actually repaid the banking system on a net basis during 1989. Claims of the banking system on the government fell by 1.5 percent in 1989, in contrast to an increase of 34.8 percent in 1988. Growth in credit to public corporations, while still high at 28.5 percent, also slowed appreciably from the previous year.

The stance of monetary policy was expansionary during 1990, in part because the effects of a sharp turnaround in the external position were not fully sterilized. Domestic credit accelerated to 15 percent from 5 percent in 1989. Broad money growth, at 20 percent, almost doubled from the level of the previous year. The government continued to limit its bank borrowing, and public corporations also curtailed their borrowing, but credit to the private sector rose by 24 percent in 1990, up sharply from 5 percent in 1989.

Following the recent trend, during 1990, monetary policy focused primarily on open market operations. Meanwhile, policy measures such as the partial credit ceiling and the 100 percent margin requirement against letters of credit on nonessential imports introduced in 1989 as short-term corrective measures were continued in 1990, and the Central Bank took further restrictive actions in the face of strengthening inflationary pressures. The Central Bank rate was raised by 1 percentage point to 15 percent in July 1990; the interest rates on Central Bank refinancing were revised upward; and yields on Treasury bills, which had declined from 18 percent at the end of 1989 to 15.5 percent in June 1990, were allowed to rise to 17.5 percent by the end of 1990. Nevertheless, total outstanding refinancing increased by almost two-thirds during 1990 to almost SL Rs 7.1 billion at the end of the year, largely because of a special refinancing facility for the establishment of a food buffer stock and facilities for the restructuring of the finance companies.

In response to intensified activities in both the primary and secondary markets, Treasury bills holdings by the nonbank sector further increased by about one-half to SL Rs 23 billion at end 1990, and the share of total Treasury bills outstanding increased from 31 percent to 37 percent. Meanwhile, despite an increase in total Treasury bill issues of SL Rs 10.4 billion (book valued) during 1990, the Central Bank’s share in total holdings declined from 57 percent to 44 percent, reflecting the effectiveness of the open market operation activities.

3. Applying Forecasting Techniques to Sri Lanka

The key variable to forecast in the monetary sector is money. Money demand functions are frequently used to forecast money, but inadequacies in data on the real national product, money, and inflation render this approach impractical in some countries. Moreover, when significant structural changes are taking place in an economy, estimated coefficients are likely to be unstable and hence are of limited use for forecasting. In the case of Sri Lanka, broad money (currency in circulation plus demand, time, and savings deposits) can be forecast using equation 7.4, which has the same form as equation 7.1. The dependent variable is the average stock of broad money in each year (deflated by the consumer price index), and the scale variable is real GDP.6 The opportunity cost variable is a measure of the real interest rate, derived as the maximum yield paid by commercial banks on 12-month deposits, relative to the percentage change in the CPI.7 Developments in the real interest rate are shown in Table 7.1. During 1978-81, the real rate was negative but turned positive in 1982 as inflation abated. Bank deposit rates rose in the mid-1980s, and the real rate moved sharply upward when inflation plummeted in 1985, while bank yields descended more gradually. In 1990 the real rate again turned negative as the inflation rate nearly doubled. This jump in inflation made the public less willing to hold money, as evidenced by the fact that actual holdings fell below the predicted level (Table 7.2), and by a rise in velocity (discussed below in this section and Table 7.3). The demand for money function for Sri Lanka was estimated as follows:



M2AVG = average of year-end stocks of broad money (currency in circulation plus demand, time, and savings deposits), in millions of Sri Lanka rupees;

CPI = consumer price index (1982 = 100);

GDPR = real gross domestic product, in millions of 1982 Sri Lanka rupees; and

FIDR = average maximum interest rate paid by commercial banks on 12-month deposits, in percent.

Table 7.1.

Sri Lanka: The Opportunity Cost of Holding Money

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Source: IMF Institute database.


Table 7.2.

Actual and Predicted Values for Monetary Equations, 1978–90

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Source: IMF Institute database.
Table 7.3.

Sri Lanka: Velocity, 1978–90

(In millions of Sri Lanka rupees)

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Source: IMF Institute database.

In terms of the accounts of the monetary authorities, an examination of Table 7.7 provides a picture of developments with respect to the money multipliers for narrow and broad money. Both the narrow and broad money multipliers declined after 1980, reaching their lowest point in 1985, but rose steadily from 1986 through 1989 before declining slightly in 1990. Excess reserves were negligible throughout the period, so changes in the multiplier reflect changes in reserve requirements, the currency ratio, and the composition of deposits. Until July 1987, the Central Bank applied different reserve requirements to each type of deposit, yielding a weighted average reserve requirement of 12.3 percent of total bank deposits at that time. In August 1987, these rates were unified and set at 10 percent.

Table 7.7.

Sri Lanka: Broad Money, Reserve Money, and Money Multipliers, 1978–90

(In millions of Sri Lanka rupees)

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Source: IMF Institute database.

The overall money supply process is captured in equation 7.9 and reflects the influence of certain Central Bank actions, such as adjustments made in the number of claims on commercial banks and in reserve requirements. However, the process also reflects developments in the external sector (NIR and MFL), the behavior of government (NDCG), commercial banks (re), and nonbank public (b and c). These developments need to be explicitly considered in the forecasting exercise, especially when one objective is to control the money supply. The estimated equation was:



M2 = broad money, in millions of Sri Lanka rupees; and

RM = reserve money, in millions of Sri Lanka rupees.

4. Exercises and Issues for Discussion

a. Exercises

(1) Complete the monetary survey for 1991 as shown in Table 7.4. Specifically:

  • Ensure that projections of the net external position and net credit extended to the public sector are consistent with forecasts made in the workshops on the balance of payments and the fiscal accounts.

  • Assess the factors affecting the demand for money and the shares of currency and foreign currency deposits in broad money.

  • Calculate credit to the private sector in the first round as a residual, but make the calculation consistent with expected developments in prices and output. Some iteration with other workshops may be needed to achieve this.

(2) Forecast the accounts of the Sri Lanka monetary authorities for 1991 as shown in Table 7.5. Be sure to consider the expected value of the money multiplier and the implied changes in the Central Bank’s balance sheet relative to past trends.

Table 7.4.

Sri Lanka: Monetary Survey, 1986–91

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Source: IMF Institute database.

Imputed stocks from January 1, 1987.

Table 7.5.

Balance Sheet of the Central Bank of Sri Lanka, 1986–91

(In millions of Sri Lanka rupees)

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Source: IMF Institute database.

Capital accounts, which net are a liability, are included in other items net.

b. Issues for discussion

(1) Review the main factors that you would take into account in estimating the demand for money.

(2) Discuss the instruments of monetary control underlying your scenario. What implications will result if the money multiplier is larger than projected? Under what circumstances is the multiplier likely to be larger?

(3) Relative to your scenario, what are the implications for monetary policy of an improvement in the balance of payments? What is the appropriate policy response to the situation?

(4) Discuss the main weaknesses of the financial system at the end of 1990. What measures can be taken to strengthen it?

(5) What are the implications of foreign currency substitution—that is, of switching money holdings out of local currency into foreign currency—for the conduct of monetary policy?

Table 7.6.

Sri Lanka: Factors Affecting Reserve Money and Domestic Liquidity, 1987–91

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Source: IMF Institute database.
Table 7.8.

Sri Lanka: Liquidity Position of Commercial Banks, 1986-90

(In millions of Sri Lanka rupees, unless otherwise specified)

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Source: IMF Institute database.

Starting February 1988, the required reserve ratio was increased to 13 percent of deposits, of which 3 percent may be held in the form of Treasury bills. Starting September 1988, the required reserve ratio was increased to 15 percent of deposits, of which 5 percent may be held in the form of Treasury bills. In January 1991, Treasury bills became ineligible in required reserves.

Includes Development Finance Credit Corporations (DFCC) bonds from September 1985 onward. Banks are allowed to hold one-tenth of required reserves on time and savings deposits in the form of DFCC bonds.

Actual reserves less required reserves.

Liquid assets less required reserves.

Liquid assets divided by required reserves.

Refinancing of advances to cooperatives to finance the purchase of paddy under the Guaranteed Procurement Scheme (GPS).

Mostly for exports.

Includes commercial bank holdings of central bank securities.

Total deposits, defined here to include government deposits.

Table 7.9.

Sri Lanka: Selected Interest Rates, 1986–90

(In percent)

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Source: IMF Institute database.

Ranges at end of period.

Average effective yield of auctions. Central Bank securities with six-month maturity were first issued in mid-1984. In March 1987, the maturity period was reduced to six months, and in September 1988, the coupon rate was increased to 14 percent. No new issues of Central Bank securities have occurred since September 1988.

Minimum rates.

Colombo consumer price index.

Table 7.10.

Sri Lanka: Problems and Policies With Respect to Stabilization and Structural Adjustment

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An early discussion of the links between monetary policy and aggregates with the financial programming framework can be found in J.J. Polak, “Monetary Analysis of Income Formation and Payments Problems,” IMF Staff Papers, Vol. 5 (November), 1957. The approach is further delineated in The Monetary Approach to the Balance of Payments (Washington, D. C., IMF, 1977).


It has been found that in some cases the logarithmic form of the function produces more robust results.


Note that b4 = 1 - β and, therefore, β = 1-b4.


Finance companies provide credit to high-risk borrowers that is concentrated in discounting trade bills and vehicle leases/purchases. The Finance Companies Act of 1988 requires companies to meet new capital standards before being permitted to re-register and gives the Central Bank increased supervisory and regulatory responsibilities for this sector. Reflecting this policy, the number of finance companies declined from 72 in 1987 to about 35 in 1990, and gross assets declined from SL Rs 8.5 billion to about SL Rs 7.5 billion over the period


Deposit rates at the National Savings Bank were increased by 2 percentage points to 15 percent in May (a move followed by most commercial banks).


Calculated as the average of the pertinent year-end stocks of money.

The real interest rate is derived from the expression

where i and irare the nominal and real rates of interest, respectively, and p˙ is the percentage change in the CPI.