Market forces will determine exchange stabilisation

by Gamini WARUSHAMANA

The dollar exchange rate stabilisation will be determined by market forces and one cannot say at what rate it will stabilise, said Central Bank Governor Ajith Nivard Cabraal.

The rupee is free to float but this does not mean that there would be no intervention at all to free floating. If there are large foreign currency inflows or outflows the Central Bank has a duty to intervene, he told a press conference in Colombo last week.

Speculation is rife in the forex market and the CB has warned speculators and added that investigations of financial institutions engaged in such activities are under way. However, Cabraal declined to comment on the speculators.

Sri Lanka's reserve levels never reached a critical stage in the recent past and even today foreign reserves are at comfortable levels. By May 8, 2012 the gross official reserves (without ACU) are estimated at around $ 5.9 billion or equivalent to 3.4 months of imports.

A reasonable increase in reserves can be expected based on projected inflows, he said.

Explaining the developments in the economy's external sector he said that 2011 was a highly successful year as a result of external sector stability. In 2011, there was a stable exchange rate; it strongly supported the import of intermediary and investment goods and capital formation that will contribute to economic growth in the future. Investor confidence was high during the year and interest rates were at a reasonable level. Here are excerpts of his speech.

The external sector stability facilitated many achievements in the economy during the year.

The high economic growth rate of 8.3 percent apart from the 8.0 percent growth in 2010, high investments of 29.9 percent of GDP, low inflation, decline in unemployment rate to 4.2 percent, over one billion FDI inflows, the highest in the country's history, accelerated tourist arrivals, $ 5.1 billion foreign remittances and over 25 percent growth in remittances and low budget deficit of 6.9 percent of GDP are among these achievements.

Pressure on external sector

The pressure on the external sector emerged in the latter part of 2011 and it was dealt in February 2012 by tight policy measures. The trade deficit increased as a result of the significant increase in the import of motor vehicles, gold, petroleum and investment goods. During the year the import of motor vehicles increased by 86 percent to $ 1.9 billion. Gold imports increased by over six-fold to $ 604 million.

The Petroleum import bill increased by 58 percent to $ 4.8 billion while the price of crude oil increased by 37 percent hitting the $ 109 barrel mark. Investment goods imports increased by 55 percent to $ 4.3 billion. This resulted in a higher current account deficit of 7.8 percent of GDP, balance of payment deficit of $ 1 billion. Gross official reserves moderated to $ 6 billion and the exchange rate was under pressure due to higher imports demand. Credit expansion was 35 percent.

To face the situation several proactive policy measures were taken in February and March. To curb high credit growth and monetary expansion policy interest rates were revised upwards and licensed banks were directed to limit credit. As a result monetary expansion is expected to moderate and inflation marginalised at a single digit level.

Widening trade deficit

The widening trade deficit mounted pressure on the exchange rate. In February, more flexibility was allowed in the exchange rate with reduced intervention. Duties on motor vehicle imports increased and forward contracts of foreign exchange were restricted. Net Open Position (NOP) limits reduced one-third of the previous exposure limits to check speculative behaviour in the foreign exchange market. Policy measures together with higher anticipated earnings from tourism and worker remittances will reduce the current account deficit significantly. The anticipated revenue from tourism is $ 1.2 billion with over one billion tourist arrivals in 2012 and the projected workers' remittances are $ 6.5 billion.

There was a risk of declining external reserves and to address the issue several steps were taken. Local corporates were encouraged to tap international markets. Banks were encouraged to raise foreign currency Tier 2 debt capital.

The Government expects around $ 2 billion FDI this year and a sovereign bond issue. The threshold for foreign investments in Government securities was raised to 12.5 percent. We expect a healthy surplus in the BOP and a steady build up of external reserves.

To reduce financial losses of the Ceylon Electricity Board (CEB) and Ceylon Petroleum Corporation (CPC) fuel prices were adjusted in keeping with global oil price and a fuel adjustment charge was imposed on electricity use. These measures will improve the financial position of the CEB and the CPC.

Policy measures

Although policy measures will mitigate emerging pressure and risk, the costs of such measures are lower economic growth and slightly higher inflation. The anticipated economic growth rate for 2012 is 7.2 percent as against the 8.0 percent targeted. The agriculture, industry and service sectors are expected to grow at 6.9, 8.4 and 6.7 percent respectively.

The slower recovery in advanced economies and the increasing global fiscal and financial uncertainties could pose a downside risk. Political and economic uncertainties in Sri Lanka's export market could also hamper in reaching the growth projection.

In keeping with these revised estimates for 2012 macro-economic variables have been revised as ashown in the table. In 2012 the current account deficit will drop to 3.8 percent of GDP compared to 7.8 percent last year. However, in 2010 it was 2.2 percent and therefore 3.8 percent current account deficit is a realistic target. The estimated BOP deficit is $ 1.2 billion while the Budget deficit will be maintained at 6.2 percent of GDP.

Inflows to the Government Securities market are performing ahead of expectations. Cumulative net foreign inflows to Government Rupee Securities up to May 2, 2012 were $ 483 million compared to the $ 500 million annual projection. Based on outstanding leeway for foreign investments in Government's Rupee Securities, a further $ 400 million can be accommodated as inflows in 2012.

At present Sri Lanka's sovereign bonds are traded at a premium and it is time for a new bond issue.

The sovereign bond issued in 2007 will mature in October this year and the Government hopes to issue new $ 500-1,000 million sovereign bonds this year.

This issue will strengthen Sri Lanka's presence in the international market and maintain the yield curve.

Stock market inflows this year have been positive and are on target. Investor sentiment is growing and the cumulative net inflows up to May 2, 2012 amounted to $ 172 million compared to the $ 500 million annual target. Net outflows amounted to $ 172 million in 2011.

Inflows to commercial banks including Tier 2 capital have been higher than expected. Commercial bank's inflows amounted to over $ 880 million.

This includes the $ 500 million international bond issue by the Bank of Ceylon.

The issue was oversubscribed seven times and was priced at 6.875 percent. Therefore, the annual target of $ 1 billion is likely to be comfortably surpassed and is estimated to reach $ 1.4 billion this year.

The projects that would attract US $ 2 billion FDI inflows include already committed projects in the pipeline such as Colombo Southern Port expansion project's terminals and Hambantota port related projects worth $ 1 billion. Among them are Sugar Refinery, Petrol Chemical Plant, Cement Plant and Fertiliser Storage, Processing and Bagging Plants.

New major projects anticipated this year are; Heavy Industrial Zone in Sampur, three mixed development projects by a Malaysian Developer, the Colombo-Kandy expressway, two development projects at D.R. Wijewardene Mawatha, Shangri-la (Colombo and Hambantota), Sheraton Hotel- Colombo, Sun city Hotel -Muthurajawela, Henegama Sports Complex, Hutchinson Telecom and Petroleum Refinery, Trincomalee.