Comments on The Present Global Financial Crisis and Sri Lankan Economy by Mr Ajith Nivard Cabraal, Governor of the

Central Bank of Sri Lanka 10 October 2008

1. The Global Economy is in Turmoil. The ongoing financial crisis originated as a result of the subprime mortgage crisis (SMC), erupted in mid 2007. The SMC erupted due to the bursting of the US Housing Bubble and high default rates on Sub Prime Mortgages, beginning 2006. The major cause for this financial crisis was the reckless providing of loans by financial institutions, particularly to the housing sector, without proper supervision, and the resulting eventual bankruptcy of such financial institutions. In other words, this is a turmoil that had been caused by the grant of loans to bad creditors, considering them as good creditors.
The SMC became more apparent during 2007 and 2008, and has now resulted in contracted liquidity in the global credit markets and banking system.
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2. What is the impact on the Sri Lankan Economy? Fortunately, Sri Lanka has only a minor relationship with the financial institutions that have got into difficulties. Because of this reason, there will not be a significant direct impact on our economy. In addition, the shift of economic policy of the present government, which has given pride of place to the domestic economy, has also prevented any kind of large scale impact, arising from the international turmoil. For example, Sri Lankas Api Wavamu Rata Nagamu policy has helped the country to withstand against the world food crisis. This has been achieved in the midst on many countries, including Egypt, Haiti, Ivory Coast and Somalia, are having Food Riots.

3. It is clear that we have been able to face the recent shocks successfully. Sri Lanka was able to confront the oil price shock with appropriate, prudent and timely measures. The decision to
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pass-through the oil prices to final consumers was one of the toughest but very prudent decisions taken by the government in the economic management front. Sri Lanka was also able to obtain a generous credit facility from Iran to lower the possible impact of a credit crunch that could have been otherwise caused due to the very high international oil prices of recent times. It is heartening that oil prices are reducing now, and we are naturally more comfortable in that scenario. As already stated, the food price shock was successfully dealt with, without a single food shortage incident or any other panic.

4. We have been resilient. Sri Lanka has been resilient against various external shocks in the face of tsunami, droughts, floods, and terrorism. Some people have expressed surprise that the recent shocks of the past and the new global financial shock has not affected us too adversely. Is it good luck? Or, did we do something right?
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We can truthfully say that it is not only our good fortune that has enabled us to face the shocks. We have carefully prepared our economy to face crises, and today, such policies and practices are paying off.

5. How did we prepare for these shocks? The prudent policies we pursued have helped us to minimize the impact of external shocks, on the domestic financial system. The Central Bank has been vigilant in maintaining stable interest rates and exchange rate to protect the domestic economy and strengthen it. Our exchange rate was stable for over one year now. We have opened the Treasury Bill and Bond Markets to foreign investors with carefully placed limits, while creating a buffer to meet the threat of a sudden capital flight. The Central Bank has been highly concerned about the adverse implications that would arise due to any indisciplined lending by banks. Because of this reason, we directed all the banks to make a general provision of 1 per
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cent on performing loans and advances, in November 2006. We also increased the Risk Weight applicable for Housing Loans from 50% to 55% in November 2006. At that time, business community and the media found fault with us. But now, we have been proved right. We placed a limit on commercial banks borrowing from abroad to 15 per cent of their capital. The Central Bank took measures to formalize and strengthen the banking supervision activities and to educate the banks on the management of risks. We also issued new far reaching and landmark directions on Corporate Governance, Limits on shareholdings, Maximum accommodation and single borrower limits, and enforced these new directions stringently. Internationally, the Central Bank invested its external reserves with highly rated international banks, basically with foreign Central Banks, and thereby ensured the 100 per cent security and safety of its own reserves. We absorbed an additional US dollars 600 million from the foreign exchange market, in the first 8 months of this year. This has enabled the Central Bank to supply such foreign
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exchange in a situation where there is a need to supply external funds into the market to keep it stable. We dealt with inflation in Sri Lanka in a decisive manner, and it is gradually declining now. We expect this trend to continue in the coming months as well. When other countries are having severe increases and are in fact doubling or tripling their inflation figures, we are experiencing a decline in our inflation rate. We took the tough decision of passing-though the high oil prices early. Most of the other countries took that decision later and are today experiencing rising inflation rates, thereby compounding the problem of the credit crunch. We indicated our policies well in advance through our Road Map, which has now become a very important way of communicating our overall action plans and policy directions. We will issue our next Road Map at the beginning of next year.

6. How are we facing the global turmoil now? We have been regularly examining our countrys financial relations with all our counterparties and financial institutions to anticipate any vulnerability. We have now been able to confirm that such relationships are very minimal and that we have suffered no damage. Nevertheless, we are aware that that is not a reason to be complacent and shall continue with our efforts in that endeavour.

We are constantly acting to avoid any liquidity shortfall in the national financial system, and this has been in fact done recently through the partial relaxation of our very tight monetary policy in order to increase the supply of liquidity to the market in the face of the global challenges. Such a measure is not unique to Sri Lanka, and in fact, Central Banks and Governments of many countries have embarked on this type of policy measure. For example, the USA recently approved the supply of US$ 700 billion to the market while the UK injected Sterling Pounds 86 billion. The Central Bank of Sri Lanka also conducts on-going discussions with the commercial banks that are having
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relationships with external banks and have repeatedly requested them to take necessary measures to ensure safety. 7. What of the future? Notwithstanding all these efforts, if this global crisis prevails for a longer period and many countries suffer from recession, Sri Lankan exports too could be affected, although in a limited way because of the nature of our exports. Therefore, exporters have to be vigilant about the situation and take the necessary measures to handle such an eventuality, and continue to improve their productivity. At the same time, the Government and the Central Bank will continue to take the necessary steps to meet the rapidly unfolding challenges. In fact, our objective is to anticipate and take the required measures in time to ensure stability. It is clear that we have done so in the recent past. We shall continue to do so in the future.

We are confident that we can face this challenge.

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