'Negative expectations lead to continuous depreciation'

Negative expectations about the country, economy, conflict and future inflation leads to continuous depreciation of the Sri Lankan rupee, said ADB economist Dr. Johanna Boestel.

Depreciation depends on the actual flows of the rupee in and outside the country. The large current account deficit and investors' worrying about the sustainability of capital account financing are some causes for these negative expectations Dr. Boestel told the 'Sunday Observer' .

What determines the exchange rate if it is freely floating is the demand and supply and we should find why the demand for the rupee is going down. Perception of higher risks means that people and exporters want to hold more dollars and convert their dollar receipts into rupees as late as possible.

The rupee is a managed float, and we have seen quite a lot of intervention in support of the rupee by the Central Bank in the recent past, as well as in the past two years, Dr. Boestel said.

The Sri Lankan rupee has depreciated 10% against the dollar, about 18% against the Euro and 26% against the Indian rupee.

The Sri Lankan rupee is depreciating while all other Asian currencies are appreciating rapidly. The Indian rupee, Thai Bhat and many other currencies are appreciating.

Actually they are worried about appreciation of their currencies as it reduces the competitiveness of their goods in international markets, she said.

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Economy not in a crisis - ADB Economist

by Surekha Galagoda and Gamini Warushamana

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Profile

Dr Johanna Boestel joined the ADB in 1999. Her first degree was in Chinese, but a one-year stint in 'Asian miracle' Taiwan to learn Chinese convinced her that economics can be at least as fascinating as classical Chinese.

As a result of which she then switched to an MSc and PhD in Economics. She took on her assignment as country economist for the ADB in Colombo in November 2003. Before joining the ADB, she was teaching development economics at the University of Kent, and working for the Economist Intelligence Unit in London.

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ADB Economist Dr. Johanna Boestel discusses a host of issues relating to the Sri Lankan economy in an exclusive interview with the Sunday Observer.

Q: The Sri Lankan rupee is depreciating continuously while inflation is also on the increase. What are the reasons for this situation?

A: The Sri Lankan rupee has depreciated 10% against the dollar, about 18% against the Euro and 26% against the Indian rupee.

The Sri Lankan rupee is depreciating while all other Asian currencies are appreciating rapidly. The Indian rupee, Thai Baht and many other currencies are appreciating. Actually they are worried about the appreciation of their currencies as it reduces the competitiveness of their goods on international markets.

We can't exactly say whether the Sri Lankan rupee is over valued or not because though there are several methods of measuring it, all of them produce different results.

For example the IMF used three methods on the Indian rupee, and the Indian rupee is either 'just right', or over, or undervalued.

What determines the exchange rate if it is freely floating is the demand and supply and we should find why the demand for the rupee is going down. [Incidentally, the rupee is a managed float, and we have seen quite a lot of intervention in support of the rupee by the Central Bank in the recent past, as well as the past two years.]

The demand for a currency is mainly related to expectations, expectation of the country, economy, how the war will be financed and the future inflation rates. Expected high future inflation rates erode the expected value of the rupee. It also depends on actual flows of the rupee in and outside the country.

Sri Lanka has a very large current account deficit. While this is 'plugged' partially by the large and growing remittances, investors are worried about how sustainable is the capital account financing. This means in short that the Government and the country has obligations to repay loans, have enough dollars to pay for oil imports, (that is on the 'capital account' side).

To do this, the Government has to have foreign exchange loans, as the Government has a few other sources of income. The more it is financed by volatile, short-term flows, the greater the risk. At present a substantial proportion of Sri Lanka's capital account inflows is t-bonds that were opened to foreign investors.

There could be fears that this might reverse. Perceptions of higher risks means that people, and exporters want to hold more dollars, and convert their dollar receipts into rupees as late as possible in the process.

There is no clear answer about the future value of the rupee, whether it will continuously depreciate or not, because expectations also drive the demand for the currency.

If people perceive a high likelihood of the value of a currency being eroded in future, they want to hold less of it now. It depends on many factors such as uncertainty about macroeconomic policies, inflation, high current account deficit, low external reserves and high fiscal deficit.

Inflation outlook

The inflation outlook is uncertain. Starting June net credit to the Government from the Central Bank has increased, which might increase inflationary pressure.

At present there is a problem of credibility on whether or not the Central Bank will be able to contain inflation. Two months ago we revised upwards our expectations to almost 15% (Sri Lanka CPI).

In addition to internal factors, there are external factors. Because globally food prices have gone up. High milk food prices coupled with the wheat shortage have been contributory factors. This situation affects many countries and in China the price of pork and other food price increases have been a serious issue. Higher oil prices too will have an impact.

However, according to CB statistics, economic fundamentals are mixed. The Trade deficit is less than last year. There is a robust economic growth and according to the half year data it is likely that the economy will grow at 6% this year.

Overall the external reserve level shrunk in 2006, but 2007 has seen some improvement, while the official reserves level has marginally increased.

External official reserves are sufficient for two and a half months of import cover (goods and services), pretty low and as a 'rule of thumb', the IMF usually would like to see three months. However, this is not the worst situation Sri Lanka has faced.

In 2000, external reserves reduced and was sufficient for only 2-3 weeks of imports. According to all these factors it would be wrong to say that the economy is in a crisis but the downside risks to economic growth have clearly increased.

Q: What measures should the Government take to control the situation?

A: Key measures are to increase revenue, and where possible to cut expenditure. This is more easily said than done. The Government is in a very difficult situation and there is a high fiscal deficit, and the Government is financing a military campaign.

The Government has identified the issue and is taking measures to tackle the situation.

Measures, successful so far have been taken to increase revenue collection and widen the tax base, but care has to be taken not to overtax those who are already paying taxes.

According to a survey, Sri Lanka has one of the highest effective tax burdens on corporate income in the world (World Bank, Doing Business Report).

Government expenditure is increasing year by year and it is difficult to trim expenditure. No Government likes to cut recurrent expenditure (wages, pensions, subsidies, and interest payments.) However, introducing new subsidies, even on a temporary basis, will be very difficult to withdraw.

For example the kerosene subsidy for fishermen that was recently introduced. The question is how well targeted is this subsidy, and can the Government really withdraw it as promised?

However, cutting capital expenditure is not the answer to contain the deficit, as it will reduce the long-term potential for Sri Lanka's economic growth.

It is literally impossible to cut expenditure such as government salaries and pensions. One-third of Government expenditure goes for subsidies and transfers. Though some subsidies are given temporarily it is difficult to withdraw them.

One solution

One solution to the problem is properly targeted subsidies to poor people who should receive them while the other solution is to reduce the losses of State Owned Enterprises (SOEs).

As Minister Amunugama said recently the Government has to carry the burden of 'six monsters', ie the six largest public enterprises, which are a considerable drain on public finance. President Mahinda Rajapaksa also called on them in his Budget speech to become more 'self sufficient'. So far we only see very limited progress.

Q: Can you name a country, which faced a similar situation and overcame the problem following appropriate action?

A: Philippines is one example. The country too faced a similar situation but by adopting fast economic reforms overcame the situation. India is another example.

Q. Overall what is your assessment about the economic fundamentals of Sri Lanka?

A: My answers to the earler questions are also relevant. Growth is still strong, but downside risks have increased mainly because of the conflict, persistent high oil prices and high inflation.

Uncertainty about how the Government will - and is able - to address these problems, and how it will tackle the trade off that each policy choice implies, have also grown in public perception.

The Policy uncertainty is there and blue chip companies have started to invest abroad. This is important on one hand, because they become multi-nationals. But at the same time it is an outflow of much needed capital from the country.

Q: In this situation what would be the economic growth rate this year, will it be on target?

A: According to the first six months performance, a 6% growth rate is possible. Agriculture sector growth was expected at 2% but during the first six months it grew at 3%. The growth in the services sector is higher with the tourism sector recovery.

Ports and banking sectors are also doing pretty well. There is a robust growth in the garment sector. Garment exports to the US, in value terms, decreased last year but exports to the EU market increased.

Infrastructure development

Q: The Government has launched a massive infrastructure development program. Do you see that the country has the potential of achieving these targets on schedule , considering the issues of finding capital?

A: Capital is not the key constraint to implement most infrastructure projects in Sri Lanka. For instance the ADB funded the feasibility study of the Norochcholai coal power project 20 years ago, and funding was there.

The issue is much more decision making in an environment with a very complex political economy. There were also protests against Norochcholai and upper Kotmale power projects (both had foreign funding).

At Norochcholai , the delay was finding a land to build the power plant. But to be fair, land acquisition always takes time be it in Sri Lanka or in other countries. In Germany building a highway took 10 years due to the problem of land acquisition.

Land acquisition that involves forced resettlement in democratic countries is a long, and tedious process. Conditionalities in safeguarding resettlement.

One of the projects that is moving smoothly at present is the Colombo Port expansion project.

Q: Will the ADB fund any of these projects?

A: We haven't really been approached. We are now discussing the new strategy with the Government.

However, the Government has to be careful in planning infrastructure projects because financing is an issue. The fiscal deficit is high and therefore the Government should consider how to finance public infrastructure through borrowing.

The economic viability becomes even more an issue. Funding large scale public investment programs with commercial loans is risky because the pay off is traditionally lower than the debt repayment.

The Government also bets that this would usher in higher economic growth. But this is sometimes beyond the control of the Government (ie the Government cannot control the economic growth rate).

Q: The Southern expressway project that the ADB funded has been delayed by many years? What are the reasons and what lessons can we learn in the implementation of these proposed projects?

A: The ADB, like the Government, is not happy with the progress of the southern highway. As a result of long delays the Government now has to pay a commitment fee.

There were many reasons including detailed designs not being sufficient, survey conditions were unknown. There were no information about how many rocks had to be blasted and again unsuitable soil had to be removed. One major issue was the slow progress in land acquisition.

However, the decision to expand the land acquisition of the highway to six lanes was a good forward thinking decision. If it is decided to widen the road, the land is 'already there'.

Q: The Government is going to raise funds from the international capital market. Is this a good decision? How are the rates now in the middle of a credit crunch? What are the advantages and risks associated with this bond issue?

Bond issue

A: I don't know why this has become such a political issue, but on the other hand it is good to have an open, public debate.

The Government was trying to get a rating from the rating agencies to prepare for the bond issue as far back as 2003. Sri Lanka now classified as a middle income country and as a result concessional funding ie. with 1.5% interest and 30 years pay back period will be phased out.

However, still Sri Lanka has access to concessional funds and the ADB has a special window, one that is LIBOR plus 0.6%.

A modest amount of external borrowing on commercial terms is sustainable as Sri Lanka is long experiencing a modest growth.

Whether the sovereign bond issue is good or bad depends on three factors. Firstly, for what purpose the Government will use this money. Secondly, how often would it raise funds in this manner. And thirdly, whether it is going to replace old, short term foreign debt with it, or not.

At the end of the last year the total stock of commercial, foreign denominated short term borrowing was $2.2 billon. If this US$ 500 million is used to retire a part of this existing debt then it is acceptable.

It changes the risk profile, and reduces the roll-over risk, as sovereign bonds are usually long term. With a short term loan, there is the risk that at the end, the lender might not want to roll over, or substantially increase interest rates.

Even if it is a new debt and if it is a one off then, yes it is OK, provided economic growth remains robust, and we are seeing gradual fiscal consolidation like those outlined in the Mahinda Chintana. But if the Government is going to do it annually it is risky and probably not sustainable.

As for the pricing - the recent global financial turmoil increased interest rates and it was high after July. But now the interest rate spreads that emerging economies such as Indonesia and the Philippines have to pay has come down again, also as part of the substantial cut in US interest rates.

Q. What are the developing countries that depend highly on international capital markets and what are the positive and negative lessons we can learn from them?

High exposure

Countries that had a high exposure to the international capital market learnt negative lessons, especially after the Asian financial crisis. After the Asian crisis developing countries avoid depending highly on the international capital market.

A recent IMF report said that most emerging economies have actually reduced their exposure to international capital markets. Countries now depend much more on the domestic market.

However, the Sri Lankan Government cannot do it, as its domestic financial market is still too shallow to allow the Government to raise 10-year bonds at reasonable prices. [Prices are also determined by inflationary expectations, and those are high at present. Long-term borrowing in the domestic market is very expensive.]

So one option would be for the Government to attract long-term capital inflows at concessionary terms for projects where both the funder (development bank) and the Government agree on conditionalities.

Q: In medium and long term what are the policies that are essential to overcome the present economic issues and achieve a sustainable economic growth?

A: In terms of openness to the outside world, and liberalisation of the economy, Sri Lanka compares well with its neighbours in South Asia.

Many recommendations can be listed, and the Government is more than aware of them, but it is difficult to implement in the present political economy in the country. It is also questionable how much of fiscal consolidation we are likely to see in the short-term with given expected high military expenditure.

As we discussed fiscal and monetary policies a great deal (the need for fiscal consolidation, and gradually tighter monetary policy), I will focus on some other crucial aspects.

For example, the number of Government agencies, ministries, and the parallel system of central and provincial government, where local governments have to rely on central administrative structures to get things done, does not make it easy to take decisions, and implement them.

In addition, there is a real infrastructure deficit - power, transport, ports and - that needs to be tackled. Very specific labour laws, while coming from a very proud tradition of protecting the worker actually reinforces the dual labour market.

This means those who are 'in' remain 'inside', but the outsiders, ie those that do not have the relatively cushy job protection, cannot get 'inside', as employers are reluctant to increase formal employment, as it becomes too expensive.

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