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Sri Lanka in danger of travelling the PIGS path with low nominal interest rates: Bellwether

Nov 02, 2014 (EconomyNext) – The results of the Uva provincial elections show that major gains have been made by the opposition United National Party, denting the strong electoral showing of the current administration has maintained up to now.

Meanwhile simultaneous fiscal and monetary policy loosening has opened up the possibility of mal-investments and asset price inflation.

The ruling United People’s Freedom Alliance coalition’s share of votes fell from 72.39 percent in 2009 to 51.24 percent in 2014. The main opposition United National Party meanwhile increased its share to 40.24 percent from 22.32 percent. In terms of absolute votes, the UPFA’s total fell to 349,906 from 418,906 while that of the opposition rose to 274,773 from 129,144 in 2009. Similar declines were seen in postal votes which reflect state workers.

The danger to economic stability from this election result is that the Rajapaksa administration may decide to go on a spending spree, rolling back any fiscal consolidation achieved over the past several years, ahead of a possible national election next year.

If the administration goes on a spending spree in the upcoming budget it will not be good for the economic stability and therefore the people, particularly the poor.

Unlike in the past Sri Lanka has less room to maneuver because foreign debt is high and the country is vulnerable to foreign investor sentiment.

Fascist Politicking

Spending sprees based on short term actions and subsidies result in high inflation, currency depreciation and general long-term misery. However because the elected ruling class, which necessarily includes the opposition, cynically cheer on such policies in poor countries, they can sway the vote base into believing that bad policies that damage them actually help them.

In many countries in Europe the end of feudal rule and the emergence of the popular vote brought fascism (or fascist nationalism, with ethno-religious undertones), an ideology that was developed in mostly in Eastern Europe after the World War I. After the end of the colonial era, such politics spread to newly independent states.

A key sign of such fascist politics is to cynically grab and run with the most opportunistic policy regardless of with cynical disregard to the actual harm it causes the population.





"One element shared by all fascist movements, racialist or not, is the apparent lack of consistent political principle behind the ideology – political opportunism in the most basic sense," notes Chip Berlot an investigative journalist who studied the fascist tendencies of modern right wing political parties even in countries such as the US.

"One virtually unique aspect of fascism is its ruthless drive to attain and hold state power. On that road to power, fascists are willing to abandon any principle to adopt an issue more in vogue and more likely to gain converts," he says.

It is because of such tendencies that the United National Party in Sri Lanka for example criticizes fuel price hikes by the current administration and the UPFA and JVP criticized fuel price hikes in 2002 and 2003.

In 2004 the Sri Lanka Freedom Party appropriated policies popularized by the Janatha Vimukthi Peramuma and cynically expanded the state by creating more tax spenders out of unemployable graduates who had already earned a degree out of the taxes of on the people. The administration also suspended an energy pricing formula that protected the economy and the poor and started subsidizing energy, resulting in 20 percent inflation by end 2004.

The UNP also promised massive salary hikes to public servants in the 2005 presidential election, which was against their own earlier policy of reducing the burden of the state on the poor and non-state workers.

In Sri Lanka such fascist opportunism is lightly referred to as ‘politicking’. It clearly shows that the economic problems in many third world countries stems not from ‘democracy’ or the just the popular vote but from fascist policies.

Sri Lanka now has less room to maneuver than in the past with bad policy because commercial foreign debt levels and loans from China are now at high levels.

About half the foreign debt is now owned by foreigners denominated in foreign money, so currency depreciation and inflation can no longer shrink the debt at the expense of impoverished domestic savers, pensioners and old people.

The dollar sovereign bonds and rupee Treasuries held by foreign investors are the most vulnerable to investor sentiment.

China has given a Yuan swap to Sri Lanka which will help meet any loan repayments to that country, if there are problems in international finance.

Fiscal Stimulus

President Mahinda Rajapaksa has already fired the first salvo by cutting electricity and fuel prices, just before the Uva elections.

Fiscal stimulus ultimately accommodated by central bank credit (printed money) in the form of energy subsidies has always been the biggest threat to Sri Lanka’s economic stability, even before there were civil wars here.

The direct risk to the economy through the exchange rate and inflation by energy subsidies is probably greater than even a war.

The last balance of payments crisis which sent the rupee from 110 to 130 to the US dollar was also triggered by energy subsidies which were financed by the banking system in 2011, when rains failed.

It is not clear that the current price cut will result in actual losses to energy enterprises, given that oil prices have been lower and coal powered electricity has pushed costs down. However it may crimp cash inflows to the utilities and reduce their ability to repay loans taken in 2011 and 2012 to subsidize energy as well as eventually service Chinese loans.

Energy prices cuts will give more spending power to the people, in the style of a ‘fiscal stimulus’ generating, a recovery in domestic demand.

With higher domestic spending, non-oil imports can go up.

With lower energy prices, profits of export companies will also go up. That means the Central Bank can allow the exchange rate to appreciate without hurting export competitiveness.

Exchange Rate

Export firms benefit from depreciations primarily through a real wage cut and impoverishing the workforce. But in developing countries where water and energy prices are not adjusted every month, they also benefit from fixed utility prices.

In 2012 however utility rates were also pushed up, taking away some of the benefits of a steep currency depreciation.

Eventually wages adjust upwards to take into account the inflation generated by currency depreciation. For currency depreciation to benefit exports, a cycle of depreciation and inflation has to take place continuously.

Continuous currency depreciation takes away any incentive to move into higher value goods which requires improvements in labour productivity. Labour productivity gains require capital, which is made difficult because currency depreciation destroys investible savings.

Sri Lanka is at the moment seeing an elevated level of trade union action compared to the recent past, and unhappiness about high prices of basic goods, which is politically damaging for any ruling party.

Currency appreciation will reduce some of those effects.

A part of the problem with high food prices however is economic nationalism, where basic food prices such as grain and milk are kept high to benefit landowners and farmers through import duty protection. Autarky was also a key component of European fascism.

At the moment with overall credit down, there is still room for the exchange rate to strengthen.

Just as currency depreciation triggers a vicious downward spiral, strengthening the exchange rate will create a virtuous cycle.

On the one hand imported fuel costs will go down, helping improve profits of energy utilities, improving their finances and ability to repay debt.

Sri Lanka’s steep rise in foreign reserves and stable exchange rates and low inflation is a direct result of weak domestic credit, which has reduced spending and therefore imports.

Loose Money

When rupee liquidity generated from dollar inflows into the country is withdrawn by the Central Bank, curtailing domestic credit, foreign reserves go up.

Along with the fiscal loosening in the form of an energy price cut, monetary policy has also loosened again.

In its September monetary policy decision, the Central Bank decided to reduce the interest paid on money deposited at its standing window overnight to 5.0 percent from 6.5 percent if a bank goes to the window more than 3 times a month.

Daily auctions to withdraw liquidity have also been suspended until further notice. This move is a type of ‘quantity easing’ when compared to its earlier stance.

Authorities want more bank credit to be given to productive activities rather than placed at the Central Bank.

While monetary policy is best loosened when private credit demand is low, there are dangers at these levels, when deposits and gilt yields are at four-decade lows already. Gilt and deposit rates are at levels not seen since the 1970s.


For one thing it is not clear that productive borrowings are hampered by interest rates alone at the current time.

It takes time for new projects to be designed, negotiated and started up. Even to get a building permit in Sri Lanka it takes several months.

It is true that the Central Bank is not printing money and the excess liquidity is all due to dollar purchases. If not for the Central Bank withdrawing liquidity, rates would have fallen even further.

But Sri Lanka has historically seen high interest rates. Such a country would be less leveraged than another country with lower interest rates which would be reflected in a lower credit to gross domestic product ratio.

The PIGS Phenomenon

While countries with historically high interest rates will be more resilient to sudden spikes in rates due to lower leverage in the general economy, it is also possible that when rates fall very sharply, a lot of bad investment may take place, leading to a big collapse later.

This happened Spain after it joined the European Union. As late as 1995 the one year Treasury bill yield was over 10 percent in Spain. By 2005 it was 2.2 percent.

Greece was the worst. In fact the so-called PIGS (Portugal, Ireland, Greece and Spain) saw the sharpest falls in interest rates when they entered the Euro. They blew the biggest bubbles and experienced the worst collapses in the 2008/2009 bank run.


It is not only credit, but also savings that may be channeled into bad investments. Even if bank credit growth is low, savings may be channeled into investments. That means low deposit rates will lead to mal-investments before savings ever enter the formal banking system.

When there were high levels of money printing from 2004 onwards in Sri Lanka and interest rates were held down artificially by authorities amid deficit spending and currency depreciation, desperate savers invested in questionable shadow banking firms and Ponzi schemes.

Anybody Ponzi schemers like Sakvithi to Danduwam Muddalali could easily attract savings amid low rates.

There was a property boom. When policy was eventually tightened after inflation rose to 30 percent, the Ceylinco group’s property units collapsed triggering run on finance companies and Seylan Bank.

In 2011 the biggest bad ‘investments’ were made by state banks in Ceylon Petroleum Corporation and Ceylon Electricity Board. Banks, especially state-run ones also loaned against gold, like lending against property.

The danger now is that a lot of credit and also savings will be channeled to speculative assets. Already the stock market has rocketed.

Indeed there is reason for stocks to go up, as a downturn from a burst credit bubble and balance of payments crisis eventually has to lead to a recovery. Low interest rates will boost corporate profits even in the absence of a demand pick-up.

Up to 2011 there was only a stock market bubble. There was no property bubble, with the 2008/2009 debacle fresh in the people’s minds.

But now conditions are ripe for a property bubble as well. Almost 7 to 8 years have elapsed from the last property bubble.

Amber Light to watch

Large flows of money channeled into easy money asset speculation could actually hinder productive investments. If the latest rate cut triggers such behavior it could have effects opposite to what authorities want.

It is strange that authorities are so worried about low private credit, when economic growth is so high according to official numbers. In the second quarter official growth was 7.8 percent. That is nothing to be unhappy about.

Doubts however have been raised about Sri Lanka’s GDP data for some time.

The latest IMF report on Sri Lanka has also highlighted a number of areas in GDP calculations where international standards are not observed.

But all this problems could be countered if the Central Bank is prepared to raise rates early when signs of trouble become visible.

This unfortunately has not been the recent experience.

In 2011 when the drought came and state enterprise borrowings went up, interest rates should have been allowed to go up, or energy prices should have gone up or both. The result of delayed action was a balance of payments crisis.

But at least there was confidence among foreign investors who waited remarkably patiently for the administration to take corrective action, which was done in 2012, one year too late, resulting in a very ‘hard landing’.

Authorities should carefully watch for negative signs and tighten policy quickly before imbalances build up.

Already the stock market is sending an amber signal.

Speculative activity is picking up but with the exchange rate stable, overall inflation has not picked up yet.

Low Rate Dangers

If rates are too people will invest in low return projects or over-leverage. Such projects will not survive when interest rates return to more ‘normal’ levels.

The current global troubles were caused by excessive low interest rates in the US from around 2001, where the Federal Reserve generated what is now called the ‘mother of all liquidity cycles’.

Remember that Sri Lanka’s interest rates went up after independence from low single digits to double digits mainly due bad policy and an expanding government and later a civil war.

Though the war has ended, policy has not remarkably changed from being state-centric and illiberal. Re-building also take resources, and it probably cancels out the war, though the fallouts will be positive eventually.

A key reason for recent lower interest rates has been greater access to foreign capital markets. A more open capital account should eventually lead to a convergence of interest rates.

But the trend has also been driven by extra-ordinary loose policy by reserve currency central banks and a thirst for high yielding speculative grade debt in emerging and frontier markets and that situation is unlikely to continue either.

This column is based on ‘The Price Signal by Bellwetherpublished in the October 2014 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.

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