Since the latest round of monetary policy easing began in December 2012, interest rates have come down steadily to around 8 per cent — low by Sri Lanka’s typical double-digit rates. Sri Lanka, unlike many emerging markets across Asia, was left relatively unscathed from the currency turmoil following the US Federal Reserve tapering of quantitative easing. The Sri Lankan rupee has held steady since mid-2012 with limited intervention by the CBSL. Not surprisingly, Sri Lanka was able to get relatively enviable pricing of 5.125 per cent on its last sovereign bond issue for US$500 million in April 2014. Indeed, the pricing on its sovereign bonds has dropped continuously from 8.25 per cent since its debut in 2007.

All this appears to point to the CBSL’s astute monetary and exchange rate management. But the road to price and exchange rate stability has hardly been a smooth one. Rather, it has been a period of excessive volatility in terms of policy reversals and short-lived credit booms, and came close to a currency crisis.

With growth high on the government’s agenda following the end of the armed separatist conflict in May 2009, the CBSL used both regulatory tools and moral suasion to persuade banks to lower interest rates from mid-2010. The subsequent spiraling credit growth fuelled an import surge that saw Sri Lanka’s current account deficit soar to 7.8 per cent of GDP in 2011. Instead of allowing the currency to depreciate — which would adversely impact attempts to draw in foreign borrowing — the CBSL drew down reserves to defend the currency. By February 2012 the country was teetering on a balance of payments crisis, exactly three years to the date that it last approached the IMF for a bailout package after a similarly untenable defence of the currency. The result was a series of policy reversals in March 2012 — moving from a ‘fixed’ to a ‘floating’ exchange rate, re-imposing import tariffs and introducing a ceiling on loan advances by banks to name a few.

Therein lies the root of the CBSL’s current monetary policy dilemma. The latest round of aggressive monetary policy initiated in December 2012 has not impressed Sri Lanka’s private sector. Credit growth in the private sector was a low 7.5 per cent in 2013 and continued to stagnate at 3.3 per cent by April 2014 compared to the same period last year. These figures once again prompted the CBSL to call for banks to lower lending rates further.

There are many underlying reasons why the private sector is slow to respond. Sri Lanka’s recent growth spurt — averaging 7.5 per cent since 2009 — is essentially driven by domestic demand financed by external debt. It is having an unintended impact on the supply side of the economy, particularly the balance between tradable and non-tradable sectors. The non-tradable sector has been driving growth, with active state involvement in areas such as construction, utilities, transport and banking. Thus, booming sectors where businesses can plug in investments are actually more limited than the overall high GDP growth numbers would suggest. It is not surprising then that in times of credit growth, much of it goes into a consumption spiral.

There are other factors to be considered in pursuing an aggressive monetary policy in these conditions. Foreign inflows to treasury bills and bonds amounted to US$2.4 billion in 2013. As interest rates fall, so too might future inflows. A second risk arises if low interest rates encourage investments with low returns, particularly in the government’s construction-related activities.

A more certain means of making monetary policy work in Sri Lanka is to focus on addressing impediments to growth in the real sectors of the economy rather than pushing hard for credit up-take. This calls for policy reforms that are perceived as truly pro-business by the private sector — intended to address competitiveness and productivity, and strengthen institutional and governance mechanisms. Only then will monetary policy play an optimum role in efficient resource allocation and support Sri Lanka’s vision for sustained high long-term growth.

Dushni Weerakoon is deputy director and head of macroeconomic policy research at the Institute of Policy Studies, Sri Lanka.