Rupee exchange rate, no impact on US dollar liabilities

- Central Bank Governor Ajit Nivard Cabraal


Central Bank Governor Ajit Nivard Cabraal says that Sri Lanka’s exchange rate for the local currency does not have any impact on the dollar liabilities of the country and that it would remain equivalent to the acquired debt.

He said: "Outstanding external debt was usually recorded and maintained in US dollar terms. The US dollar denominated debt is acquired and repaid in US dollars

As long as the country will utilize externally funded loans effectively for the projects and those projects generate sufficient economic returns to the country in the future to repay debt obligations, the currency risk arising due to borrowing in. As long as the country will utilize externally funded loans effectively for the projects and those projects generate sufficient economic returns to the country in the future to repay debt obligations, the currency risk arising due to borrowing in foreign currency and investing in local currency can be managed.

Here, the CBSL Governor is in conversation with The Island Financial Review:

Q: What are the plans in place to solve Sri Lanka’s Current Account issues in the light of the remittances that the country currently depends on to bridge its trade balance is largely made out of expatriate worker remittances (where a major portion is generated through remittances from house maids), while this clearly is a sign of country’s poverty, a policy should be in place to change such a situation in the long run. Apart from the some programs that are in place to encourage "skilled worker remittances", at a national level, what are the policies that the government has implemented?

One has to look at the current account deficit from an overall macroeconomic point of view rather than too simplistic way of only looking at remittances inflows in order to finance the trade deficit.

In the macroeconomic framework, current account deficit is the mirror image of savings-investment deficit which arises due to insufficient domestic savings that is required to finance necessary levels of domestic investments needed to maintain relatively high level of growth. Sri Lanka has run a current account deficit for more than three decades mainly because domestic expenditure in terms of investment and consumption has been higher than available domestic savings. During some periods, expenditure on war and other recurrent expenditures were the main cause of this higher expenditure ,and of other times very large public investment projects has been driving higher expenditures and hence current account deficits. For example, large current account deficits during early 1980s were mainly due to the accelerated Mahaweli project, large housing schemes etc. and in the recent years, large infrastructure development initiatives introduced by the government has been the main reason for the current account deficit. Such current account deficits are useful in terms of maintaining high economic growth at present as well as expanding country’s capacity to grow in the future. Enhanced capacity by this way is expected to generate sufficient income and future domestic savings in order to service future debt or dividend obligations arising from financing such deficits by way of debt or equity inflows.

Over the past several years, Sri Lankan authorities have taken several initiatives to bring the current account deficit to sustainable levels. One such initiative is to encourage workers’ remittances through increasing the level of skilled and professional migration. We can see a sharp increase in workers’ remittances and it has become an important source of foreign exchange earnings for Sri Lanka. Especially, contribution from the skilled and professional level migrant workers are increasing and there is a tendency for it to increase further with the government’s efforts to build up a skilled workforce in line with the requirements of the international job market by establishing vocational and technical training centres.

Dependence on remittances is certainly not a sign of poverty. Poverty levels in Sri Lanka have come down significantly in Sri Lanka from 22.7% in 2002 to 8.9% by 2009 while unemployment is at record low levels. In this regard, Sri Lanka is in a much better position than its regional peers. At the same time, remittances have been growing at a steady pace during past few years. Therefore, it is very clear that increasing remittances cannot be associated with poverty.

Apart from that, significant improvements could be seen in inflows to the services account, especially in tourism and IT & IT enabled services (ITES) such as BPO and KPO. Initiatives have taken at the national level to fast track the development of the IT and ITES sector by providing tax and other incentives and concessions. Sri Lanka is also positioning itself to be one of the most sought after tourist destinations, thereby aiming to reach 2.5 million tourist arrivals with annual foreign exchange earnings of about US dollars 3 billion by 2016 while increasing direct and indirect employment to 500,000.

Q: Now a word on Capital Account issues… where your debt is growing faster than your FDIs. What is the comfortable foreign debt component (in your debt stock) in the long term (as at end 2011 it stood at 33%)...

Comparison between foreign borrowings by the government and FDI inflows to the private sector is not valid as these two are not substitutes.

Sri Lanka has run a fiscal deficit on average almost 10 per cent of GDP since 1977 up until mid 2000. As a result of such high deficits which were financed mainly through borrowings, debt stock reached the peak of 105% of GDP in 2004. Since then, the fiscal deficit has been brought down now to around 6% of GDP despite the period of intense stage of war until 2009 and largest ever public infrastructure programs implemented by the government since 2005. Further, as a result of prudent fiscal management, the debt to GDP ratio has now been reduced to around 80%, and the government has committed to bring down the debt to GDP ratio to 65% by 2016.

As we all know, foreign direct investment is influenced by political and economic stability, tax and other incentives, labour regulations, work ethics, social and economic infrastructure, and costs of production, potential domestic market and an overall assessment of political and economic conditions. Especially, after a financial crisis it takes some time to recover FDI inflows. FDI inflows prior to year 2005 have been around only US$ 200 million per annum on average. Since the end of war, it has been increasing sharply. For example, Sri Lanka recorded the highest ever gross inflows of FDI in 2011. FDI increased by 500% to US dollars 1 billion during 2011.

Therefore it is very clear that FDI inflows are growing at a very fast rate although non comparable with debt flows to the government. From the country’s balance of payment point of view, Sri Lanka cannot wait and only rely on FDI inflows to bridge the savings investments gap. Thus, it has to make use of foreign debts also, to continue the growth momentum without any disturbance. However, with the economic development, investor confidence is expected to grow further inducing the FDI inflows in future. There is strong evidence that foreign investors’ confidence on the country has risen sharply. Sri Lanka’s fifth international sovereign bond was issued successfully with an oversubscription rate of over 10 times, reflecting the positive investor confidence on Sri Lankan economy. The positive investor sentiment will be further buoyed by continuous improvement in the country’s ranking in global competitiveness and ease of doing business indices from 98 in 2011 to 89 in 2012 and 81 in 2013. Improvement in ranking will also create a conducive environment for the local and international business community and for investors. It is reported that Sri Lanka is the highest ranking country in South Asia and is the only country in the region to improve its ranking in 2013. Increasing inflows to the stock market and T-bonds and bills market by foreign investors also confirm increasing investor confidence in Sri Lanka.

Q: Sri Lanka’s base line economic forecast talks about a total debt to GDP ratio of 60% in 2016 (vs.78% as at end 2011)

• For this to happen, the economy is expected to grow above 8% during 2013-2016 (source Central Bank Annual Report- 2011)

• What are the broader supply side policy measures that you have taken to address this issue (as AD management policies are highly unlikely to take you towards these slated goals)?

Decline in Debt to GDP

The country’s debt level is assumed to be sustainable as long as the growth rate is above the real interest rate of that country together with improving primary deficit of the government. Annual economic growth of around 7-8% together with the announced fiscal consolidation path will easily bring down the debt to GDP ratio to around 60% in exactly the same way it was brought down to around 80% by 2011, from the peak of 105% in 2002. Short-term aggregate demand management policies are anyway not supposed to bring medium to long term high economic growth. Such policies are meant for short-term stabilization purposes which will maintain macroeconomic stability. As I mentioned earlier, several other important improvements in the economy and large infrastructure developments will enhance the capacity to grow, and thereby sustain the higher economic growth as envisaged in the medium-term macroeconomic framework.

Q: A strong 68% of domestic debt comprised non bank domestic debt as at Aug 2012, what constitutes this non- bank domestic debt?

The non-bank sector comprises pension funds, provident funds, non-commercial banks (particularly the National Savings Bank), Insurance funds and individual investors.

Q: While 33% of Foreign Exchange debt is denominated in US $, what was the increased debt burden in Rupee terms on the economy due to the currency weakness seen in the first half of the year?

Our country’s outstanding external debt is usually recorded and maintained in US dollar terms. In the meantime, the US dollar denominated debt is acquired and repaid in US dollars. Therefore, the exchange rate for the local currency does not have any impact on the dollar liabilities of the country and it would remain equivalent to the acquired debt. As long as the country will utilize externally funded loans effectively for the projects and those projects generate sufficient economic returns to the country in the future to repay debt obligations, the currency risk arising due to borrowing in foreign currency and investing in local currency can be managed. The currency risk, which is inherent, is taken into account when foreign loans are obtained.

Q: As evident from the following graph, Central Bank’s (CBSL) sterilized intervention in the forex market especially during the second half of 2011 resulted in increased pressure on the external value of the Sri Lanka Rupee consequently compelling the Government to devalue the currency by 3% followed by CBSL’s tight monetary policy. So, what are your views on;

a) Sterilized intervention in the forex market to control interest rates and exchange rates?

b) As "monetarists" explain, won’t this kind of scenario eventually lead to an increase in the general price level (which we are slowly witnessing now)?

We have also seen some local politicians calling themselves experts, who have very poor knowledge in Monetary Economics argue that sterilized intervention could increase the general price level. In fact, the opposite is true. According to monetary theory, and the practice of many central banks all over the world, it is very clear if central banks don’t sterilize volatile capital flows it would lead to very volatile output, inflation and instability in the financial system.

If a Central Bank was to allow forex inflows to come into a country without absorbing such inflows, this would lead to an expansion in the country’s money supply thereby eventually leading to inflation. In addition, the continued inflows would cause the country’s currency to appreciate thereby eroding the competitiveness of its exports.

Moreover, in Sri Lanka, inflation has been maintained within single digit levels over the past 46 months reflecting stabilization of prices to a great extent. This is, by far, the largest ever period in our economic history that single-digit inflation has been maintained. In that scenario, it will have to be admitted by all that our policies have been working. The recent increase in inflation is also not due to sterilized intervention, but due to one-off impact of the bold policy measures introduced in the early part of 2012.

Q: Historical economic analysis of economies explain that in order to have a real economic growth rate of >8% ,a country should ideally maintain a investment to GDP ratio of >35%, however CBSL expects the investment ratio to rise to only 33% levels in the medium term, do you see this as an achievable target, if so how?

Basics of economic theory tell us that investment to output ratio is not a static value for all time. It depends on productivity of investment which naturally comes with improving technologies. Therefore, the required levels of investment to generate a fix amount of output would decline over a period of time, with improvements in productivity. Therefore, a fixed ratio of investment to GDP is not a reasonable and rational measure or a basis to estimate the adequacy of investments.

Q: Can you please explain the expected nature of assistance by the World Bank and the IMF in order to uplift the Sri Lankan economy going forward?

The Sri Lankan authorities have clearly stated that they look forward to the continued close engagement with the IMF after the successful completion of the SBA with the IMF which provided us US$ 2.5 billion for balance of payment support. The IMF has also said that they are willing to extend more support to Sri Lanka, and therefore both parties are now examining the most appropriate option to go forward. There are many instruments available and we intend to discuss appropriate way forward in the coming months.

At the same time, as a consequence of achieving a middle-income status, Sri Lanka has now acquired access to International Bank of Reconstruction and Development (IBRD) financing as of 2012, allowing for significantly increased financial support from the World Bank during the coming years.

Apart from that, Sri Lanka has the continued access to the facilities provided by the International Development Association (IDA), the lending arm of the World Bank.

Q: Multilateral agencies have downplayed the growth forecasts for the entire world. How do you see this impacting exports?

Growth in emerging market and developing economies was marked down, but are still expected to record faster rates than the current year. This means the external demand for Sri Lankan exports is expected to be higher in the coming years than this year. Since we have improved macroeconomic stability now, as a result of bold reforms introduced at the beginning of the year, Sri Lanka is now well placed to take advantage of higher global growth in the next few years.

Q: How do you see the credit crunch arising from this due to possible pullouts from stock markets and capital markets?

We saw a global credit crunch in 2008 after the collapse of Lehman Brothers and we were able to navigate that situation very successfully even with less macroeconomic buffers. Now there are no signs of a similar credit crunch in coming years, and we have seen a lot of quantitative easing in advanced economies which result in large capital inflows to emerging countries. Now the challenge among policy makers in emerging markets is how to manage such capital inflows rather than a credit crunch. Having said that, even if we were to face a credit crunch, now we have developed significant policy space by way of much higher international reserves, low fiscal deficit and debt levels, stable inflation, output and external current account deficits. So we are well prepared now to face any shock.

Q: Under these circumstances, how do you see the Balance of Payments?

As we explained, we can manage balance of payments under any external vulnerabilities.

Q: Is this the reason for the government approaching the IMF for another US$ 500 million facility?

The Government has not approached the IMF for balance of payment support. The IMF has offered us several options for successive program. As explained above, it is up to the government to decide what would be the most appropriate way to engage with the International Monetary Fund in the future.

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