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Sri Lanka should not cut rates, but look at tightening ahead: IMF

Sep 19, 2015 18:15 PM GMT+0530 | 1 Comment(s)

ECONOMYNEXT - Sri Lanka should not cut rate policy rate as core inflation is rising steadily and credit is expanding a high rates and authorities should look ahead at tightening policy, IMF mission chief to the country Todd Schneider said.

Sri Lanka's low rates may have been justified by low inflation and slow credit in the past and was not "necessarily inappropriate" he said.

"You are still in a very low inflation environment. At least headline inflation has been low," Schneider said in Colombo.

"We - looking at the balance of macro-economic factors - think that there is not necessarily further room for cutting," Schneider said.

"If anything the Central Bank should have a pro-tightening bias looking forward."

Underlying Factors

Rising core inflation and a pick up in credit, signalled the need for tightening, Schneider said.

Core inflation has been rising steadily from 0.8 percent in February before a budget raised state spending and consumption adding fuel to private credit which was already picking up, analysts say.

Core inflation does take into account food and energy, which were cut by the state.

"That (core inflation) has been rising very steadily from the beginning of the year," Schneider said. "Now that is about 3.9 percent, which for core inflation is - you are getting into the upper limit."

Core inflation strips out food and energy, most of which are internationally tradable and which some economists say are mostly influenced by Federal Reserve policy. When the dollar rises, traded commodities tend to fall.

Non-traded items can signify the domestic inflation generated by a central bank in a pegged exchange rate country though it does not encompass the total (imported and domestically created) inflation.

Credit Rise

Sri Lanka's private credit has also been rising.

Private credit rose 19.4 percent in June 2015 from a year earlier, from slow or negative levels up to the third quarter of 2014.

"Clearly it (private credit) is accelerating and that calls into question how much is too much," Schneider said.

"Credit needs to grow in line with the economy, so it is worth watching.

"For those reasons we are advising caution to the Central Bank. We are seeing pressure in terms of core inflation, pressure in terms of higher private sector credit."

Slow and negative credit helped build up excess liquidity on the liability side of the Central Bank's balance sheet and foreign reserves on the asset side.

When credit picks up, the cycle reverses unless rates rise to generate more (real) savings to finance the credit by delaying some consumption.

Other analysts have said the far bigger problem than the private credit, is the sudden rise in state credit after a revised budget in January 2015 with higher state salaries and subsidies, which created a consumption bombshell in the country as well as demand for state credit.

The private sector is a net saver but it has to generate financial savings to finance its own credit and that of a profligate state. Net credit to the government was up 21.5 percent to June 2015 from a year earlier.

Credit to state corporations rose 38.2 percent up to June from a year earlier.

Deadliest Credit

Analysts have said that even more deadlier to any country and particularly any country with a 'soft' or 'non-credible' dollar peg is central bank credit or printed money.

Due to a so-called managed float, where large inflows are bought by the Central Bank generating liquidity, analysts say the country's monetary system is fundamentally externally anchored to the US dollar via soft-dollar peg.

Any illusions that the monetary system is domestic anchored in terms to a price index is a pipe dream, they say.

When rates do not go up with loan demand, the credit system gets fouled up by contradictory polices involving attempts to target the dual anchors. When it persists for an extended period of time, a so-called 'balance of payments crisis' develops.

A central bank which purchases domestic assets (Treasury bills) inserts loanable reserves into the banking system, allowing banks to give private or state credit over and above the deposits they are generating, firing demand out of line with real economic developments.

This extra credit then slams into the balance of payments sucking up foreign reserves when the exchange rate is defended, or de-stabilizing the soft-peg with the US dollar and impoverishing the people in general (destroying real purchasing power), if interventions are not made.

The extra credit which is out of line with deposits, can come from money freshly minted to buy T-bills or releases of liquidity held through central bank's own securities or borrowed bills from a third party.

When forex interventions begin, and liquidity is sucked up, the Central Bank injects more liquidity to defend its policy rate (contradictory exchange and monetary policy), firing a vicious negative feedback loop, which can be ended with a float.

Central Bank credit to the economy rose 30.8 percent up to June according to official data, as net foreign assets of the monetary authority dropped 23.8 percent to 538 billion rupees during the same period.

Since June, central bank credit has ratcheted up further. The Treasury bill stock of the Central Bank rose to 171 billion rupees by September 18, from 5.0 billion in June 01.

Since the credibility of the peg has been undermined some of the injections have been made to facilitate fleeing foreign capital and not all of the credit is hitting the balance of payments as imports, analysts say.

To end Sri Lanka's soft-peg currency problems and inflation economists and analysts have called for an end to contradictory exchange and money policy by re-establishing a currency board or hard-peg.(Colombo/Sept17/2015 - Update II)



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  1. MetteyyaBrahmana November 06, 05:22 AM

    Schneider is not accounting for the lack of full employment in Sri Lanka, especially among recent university graduates, and the recessionary risk of tightening 'before' sustainable high growth is achieved, which would put even more people out of work.Many of these university graduates may be encouraged to start businesses or join start up companies if easy credit remains for at least the next two years, and this business activity will have a net positive effect on the overall economy in Sri Lanka.Also, not sure about the 3.9 core inflation number given the rupee's fall so far this year, which jacks up the price of imported goods. Sri Lanka is not in a position yet to substitute these imports with locally produced goods, so a weak rupee strategy at this point may artificially boost inflation more than it does exports.And in high growth developing economies, as opposed to developed economies like Europe and the US, 3.9 may NOT be the limit. If you look at places like Singapore during their developing phase post 1976, core inflation of 6 7 was the upper limit, not 4.

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