Sri Lanka warned against election spending amid soft-peg trouble
ECONOMYNEXT – Sri Lanka’s central bank has warned the finance ministry against election spending in 2019, saying credit downgrades could lead to country being locked out of international capital markets, amid a loss of credibility in the country’s soft-pegged exchange rate.
Three global credit rating agencies downgraded Sri Lanka to a ‘B’ level rating in November from B+ after President Maithripala Sirisena appointed Mahinda Rajapaksa as Prime Minister triggering a political crisis.
"If we have an undisciplined budget and poor policies, we will get downgraded again, we will lose access to capital markets," Central Bank Governor Indrajit Coomaraswamy said, while criticising the ratings agency for the downgrade without actual fiscal slippage.
"We won’t have foreign exchange to pay for our imports."
"We would have to compress our imports dramatically, people’s living standards will deteriorate dramatically and there will be austerity."
Sri Lanka operates a sterilizing soft-peg against the US dollar, which weakened in February/March after the central bank failed to mop up inflows and stopped outright and term sales of sterilizing securities, triggering balance of payments pressure and depreciation.
Central Bank data shows that the rate demanded by the credit system for 58 day sterilization securities sale by the central bank rose from 7.62 percent on February 14 to 8.2 percent for a 56 day security on March 02, after which mopping up ended.
Sri Lanka is now sterilizing in the opposite direction, injecting cash into the banking system leading to a steady deterioration of forex reserves and currency depreciation, despite better fiscal performance and market pricing of oil.
The central bank said it was not printing money to ‘monetize’ debt (directly finance the budget with printed money) but for monetary policy purposes.
"I wish to emphasise the fact that OMOs (open market operations) are a strategy to manage market liquidity to align short term market interest rates with the policy stance and not a mechanism to print new money by purchasing or holding Treasury bills by the Central Bank as wrongly interpreted by some analysts," Governor Coomaraswamy said.
"A clear distinction must be made between such OMOs, widely practiced by central banks, and monetising the fiscal deficit through the central bank purchasing Treasury bills issued on behalf of the government."
As a soft-pegged central bank Sri Lanka defends an exchange rate and then prints money to defend a policy rate, preventing a contraction of reserve money and maintaining the ability of banks to give credit.
Though the original loss of credibility of the peg may be unrelated to the budget deficit, and may be purely due to monetary policy, once the credibility of the peg has been lost and investors and exporters react, deficits which expand credit demand will worsen pressure and make it more difficult to restore confidence.
The central bank has depreciated the currency from 153.80 to 183.00 to the US dollar over 2019, making it one of the worst soft-pegs in the region.
Sri Lanka was expected to run a deficit of 4.6 percent of gross domestic product for 2018, down from 5.5 percent a year earlier.
Next year the government was originally planning to run a 3.5 percent deficit, though doubts are now emerging whether it can be done.
Coomaraswamy said the 2018 budget target may be missed, though the finance ministry is expected to run a primary surplus in the budget for the second successive year.
"Although the government continued its efforts towards fiscal consolidation, the performance on the fiscal front was rather mixed in 2018," Coomaraswamy said.
"Lower than expected revenue collection is likely to challenge the achievement of the targeted budget deficit for 2018."
However, the state will record a primary surplus for the second consecutive year, he said.
The new Inland Revenue Act, improving tax collection and the full rollout of an online tax system will help improve government income, he said.
Rationalised expenditure and better management of state enterprises will also help improve the budget deficit, Coomaraswamy said.
Sri Lanka is market pricing oil, helping the balance of payments when import prices rise by curtailing disposable incomes people and reducing non-oil imports.
But on the balance of payments market pricing is a double edged sword.
When oil prices are cut when global prices fall, there is no support for the balance of payments as people will spend the money on non-oil imports.