Interest Rates Have Increased, Now What?
The government didn’t surprise anyone when they increased interest rates last week. Policy rates went up by as much as 75 basis points. This was a part of the IMF’s demands in return for giving Sri Lanka the next tranche of the credit line they opened up for us a long time ago. It was a situation where the Central bank had to increase the rates or be denied the much needed foreign exchange.
Sri Lankan is somewhat caught up in a situation where its experiencing its history repeating itself. On numerous occasions in the past, i.e. 2001 and 2009, Sri Lanka has seen a similar set of economic dominoes toppling. The Central Bank has always at some point kept pegging the dollar to keep the rupee artificially high. Simultaneously interest rates have been somewhat low and have given encouragement for more imports. This has ultimately resulted in more and more pressure on the exchange rate as imports exceeded exports, inevitably resulting in the Central bank always relenting at the last moment and floating the Rupee, just in time to avoid a Balance of Payments crisis.
But when you float the Rupee, and the Rupee suddenly plunges, you create a lot of uncertainty in the market. Importers are worried that the rupee will fall even more and will therefore try to import even more in expectation of this. Exporters will similarly keep their dollars out of the country in expectation of the Rupee falling further, because they know that by bringing in Dollars when this situation unfolds they can get more bang for their buck, so to speak.
Now this situation will prevail as long as interest rates remain at the same, low level. Exporters and importers can still afford to borrow from banks and the former can afford to keep their revenue in dollars until he can use them to increase his gains. When this situation persists, the rupee will automatically fall further, making it a self fulfilling prophesy. The only thing that can stop this slide is an increase in the interest rate.
And like before, the Central Bank seem to have given the correct positive signal to the market. After dipping to about 131 Rupees per dollar in mid march, the rupee stopped at some 128 Rupees per dollar at the end of the month.
Aside from interest rate and exchange rate manipulation the Central Bank is also undertaking several micro moves to reduce imports. The whopping taxes on liquor and vehicles are a good example. These moves however, are not seen in a favorable light by the IMF. The IMF prefers more macro oriented moves that target the broader economy, and frown upon specifically targeting things like vehicle taxes. The philosophy being that no central power should have the right to dictate what the public should consume and shouldn’t consume. It should allow for the maximum freedom of choice between options, and should only control those variables that are common for all consumption i.e. variables like exchange rates and interest rates.
But of course a pure approach like that probably wouldn’t work well for an economy as mixed as Sri Lanka’s. We do import a disproportionate number of vehicles. And our imports do create a serious threat to the health of our Balance of Payments. Investment imports and imports of durable goods (the former include industrial vehicles, machinery and the latter includes white goods and vehicles) claim a significant chunk of our overall imports. Most of these will reduce now that the exchange rates and interest rates have been adjusted.
Whether the exchange rate improves further will depend not only on our trade balance but also on how much foreign inflows we get. As of now, inflows like Malaysia’s purchase of a significant chunk of JKH and the purchase of 5% of Aitken Spence by a foreign entity have been surprise inflows that the government seems to have secured by selling shares owned by the EPF. What Sri Lanka would ideally need would be solid flows in terms of FDI, like hotel projects and other manufacturing projects. For this to happen more, we must get down to focusing on improving the business climate here. That includes not only infrastructure but also human capital improvement and a focus on the Ding Business Indicators.
In the near term however, things are going to be a little harsh. Inflation will experience a sharp uptick but commodity prices may remain low depending on global and local market conditions. But on an overall basis, it’s time to tighten our belts a bit.
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