Sri Lanka has high currency risk, debt could jump further from depreciation: IMF

ECONOMYNEXT – Sri Lanka’s debt which had already jumped after the latest collapse of the rupee, could rise steeply if deprecation continued the International Monetary Fund has warned saying currency risk was high.

“Public debt is estimated to have increased significantly to about 90 percent of GDP at end-2018, reflecting weaker economic performance and the sizable depreciation of the rupee,” an IMF debt sustainability analysis noted.

“Currency risk, notably related to the U.S. dollar, is high.”

The IMF however had nothing to curb the monetary indiscipline and Sri Lanka’s deadly ‘flexible exchange rate’, a highly unstable soft-peg backed by contradictory money (excess liquidity) and exchange (downwardly skewed convertibility undertakings) that lead to sudden losses of credibility in forex markets and steep collapses of the rupee.

Critics have pointed out that fiscal gains made by politically costly tax increases have been wiped out by currency depreciation of Sri Lanka’s soft-peg.

In 2018 the flexible exchange rate collapse had led to a 7.4 percent increase in public debt.

The IMF said a eat map analysis indicates “high risks” to debt sustainability.

“The debt burden benchmark of 70 percent of GDP and gross financing need benchmark of 15 percent of GDP are exceeded in the program and the shock scenarios during the projection period,” the agency said.

“Debt profile analysis indicates a moderate degree of vulnerabilities related to market perception, external financing requirements and debt denominated in foreign currency.

“The share of debt held by non-residents is above the high-risk threshold.”

Analysts had warned that the IMF program itself was flawed in not placing ceiling on domestic assets of the central bank which would stop the agency from printing large volumes of money to push down call rates or for other reasons and help build up reserves permanently.

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Call Rate Targeting

Analysts have also called for wider policy rate band, which would limit any injections to a minimum through a ceiling rate window and allow short term rates to adjust upwards if there are spikes in credit which move rates.

Instead the central bank has been allowed to target a call money rate with massive bouts of money printing (liquidity injections) of up to 50 billion rupees at a time (about 5 percent of the monetary base).

In addition to liquidity injections the convertibility undertaking of the so-called ‘flexible exchange rate’ are also skewed against the rupee, with a ‘disorderly rule’ before the peg is defended ( a weak side convertibility undertaking), and no similar ‘disorderly rise’ before dollars are bought especially from the Treasury.

Dollars converted by the Treasury generate expansions of base money instead of contributing to currency stability, a chronic problem dating back decades to Sri Lanka’s currency depreciation, analysts have said.

The IMF has also not stopped any Soros-style currency swaps, which also leads to base money expansions and liquidity injections, in the course of operating the ‘flexible exchange rate’.

Sri Lanka’s central bank set up after independence from British rule when the rupee was around 4.70 to the US dollar in South Asia and the Middle East is the worst performing central bank falling to 180 to the US dollar.

The next worst performing central bank is Pakistan at 155 to the US dollar. Central Banks of both countries regularly drag the countries to the IMF without reforming the pegs with consistent policy.

According to the IMF Sri Lanka needs a ‘reserve buffer’ to help manage foreign debt/ ruling out a floating exchange rate.

Depreciation Risk

There were “vulnerabilities linked to inadequate reserve coverage, exchange rate depreciation, and deleveraging could pose a risk for debt servicing.

“Large rupee depreciation could pose a significant risk, if sustained as stress tests show that a 30 percent real depreciation could raise the external debt-to-GDP ratio to about 80 percent by 2024,” the IMF report said.

Foreign debt was now 59 percent of GDP by end 2018.

There have been calls to reform Sri Lanka’s central bank into a peg with consistent money and exchange policies (like Dubai, China until 2005, Nepal, Maldives, Hong Kong or Singapore) or a floating rate with a tight inflation target, which will reduce discretion.

However under reforms planned a ‘flexible inflation targeting’ framework is planned side-stepping genuine inflation targeting. The flexible exchange rate is to be institutionalized. (Sri Lanka to institutionalize ‘flexible exchange rate’ in new monetary law)

The IMF did not stop Sri Lanka from targeting a Real Effective Exchange Rate Index.

Instead it did provided calculations to show that the rupee was ‘overvalued’ encouraging a devaluationist philosophy prevalent in the country.

After steep currency falls the rupee was overvalued by 5 percent based on one model (external balance estimates), 9 percent by another. Under a third method the rupee was undervalued by 9 percent. (Colombo/Nov06/2019)