Fast eroding foreign exchange (forex) reserves and a ballooning trade deficit has led to internecine warfare between Sri Lanka’s two economic policy setting organs; i.e. its Treasury and Central Bank (CB) such that the latter was kept in the dark when President Rajapakse announced the unanticipated 3 percent devaluation in the rupee-US dollar (USD) exchange rate to 113.89/90 during his budget speech.
Rupee trading had to be halted and several hastily arranged conference calls were held with foreign investors, who fund Sri Lanka’s rupee denominated debt, to assuage their concerns that further devaluations were not imminent.
The International Monetary Fund (IMF) believes that the rupee is not less than 20% over-valued. However the CB has resisted calls by the Treasury and IMF to freely float it. Such an action would result in Sri Lankan expatriates –a large source of forex- who park their money in high interest rate domestic deposit accounts suffering capital losses in excess of any income they generate through interest. Foreign investors who bought rupee bonds issued by the government would also suffer deterring further investment in rupee denominated assets. As a result the final two tranches of the USD 2.5 billion facility negotiated with the IMF have not been disbursed.
Sri Lanka’s trade deficit will top USD 10 billion in 2011 and will continue growing in 2012. The reason being while Sri Lanka’s largest export markets, the US and EU suffer from weak or no growth, its imports are inelastic; i.e. not sensitive to changes in price. Sri Lanka imports all its essential goods from food, e.g. wheat and sugar, to its energy needs. Even coal and oil needed to generate electricity are imported. Inputs into its largest export, textiles, are imported – it does not manufacture the yarn or the capital goods necessary to produce the finished good. Defending the rupee at its current level while its export competitors have devalued their currencies by as much as 40 percent makes its produce expensive.
High crude oil prices and the Sapugaskanda oil refinery’s absolute reliance on Iranian crude is another negative drag. Sanctions by the US, EU, and Australia on Iran will compel Sri Lanka to import oil from more expensive sources. With petroleum accounting for 25 percent of imports, its trade deficit will come under further strain.
Foreign Direct Investment (FDI), a source of forex will undershoot the forecast of USD 750 million for 2011. Sri Lanka changed its FDI accounting rules to include the sale of the site of its former Army Headquarters to the Shangri-La hotel group to inflate this number. A lack of transparency, poor governance, a highly unionised labour force, and, the recently passed expropriation law have been contributory factors.
Growth in tourist arrivals from Western Europe, 37 percent of arrivals, will slow due to its debt crisis. India and East Asia account for 20 and 11 percent of tourist arrivals respectively. The task facing Sri Lanka is to adequately substitute premium European arrivals with budget Asian arrivals. Generating over USD 1 billion in revenues for this sector will be challenging in 2012.
Ongoing turmoil in the Middle East will have long term implications for remittance inflows and Sri Lanka’s largest forex earner, approximately USD 5.2 billion. Migrant labour will struggle to access this market. Also, it will affect demand for Sri Lanka’s top agricultural export -tea exports to the Middle East and North Africa comprise 55 percent of Sri Lanka’s total tea exports.
Sri Lanka’s aggregate economic data is somewhat misleading. Despite a consensus projected economic growth rate of 7.5 percent for 2012, its South is expanding at a slower rate while the Northern and Eastern provinces are growing at double digits, albeit from a low base. Also, the veracity of its data is not beyond doubt.
All of this led Fitch, one of three leading rating agencies, to rank Sri Lanka among the highest-risk financial systems in the Asia-Pacific region in a special report published in December. In January, Moody’s, another of these agencies, cited Sri Lanka as being still vulnerable to external shocks given its lower than expected year-end foreign exchange reserves.
Fate of the Rupee in 2012
The CB spent over USD 2 billion defending the rupee between August and December 2011. Its forex reserves fell from a peak of USD 8.1 billon in July to 6 billion by year’s end. Confronting such headwinds with its lack of competitiveness, the only choice the CB has is when to devalue. No doubt it will try to kick the can down the road, but, for a country short on options that road is not long at all. Of course, it is making every effort to generate reserves. It has entered into a bilateral loan with Malaysia, and, its weakening economic metrics imply that it will increasingly have to rely on such debt as access to capital markets will become difficult. The result of such a shift will no doubt have second-order consequences for its foreign policy as the mix of its creditor nations change.
Inelastic import demand implies that devaluation will not result in a drop in the quantity of imports, just higher rupee prices. And, along with it come not just economic but social problems for which there is no short term fix. They include:
-a higher rate of inflation.
-Higher inflationary expectations among consumers which itself causes the inflation rate to rise.
-An erosion of real incomes and purchasing power.
-A necessary increase in interest rates and the tightening of credit to contain inflation.
-Lower economic growth.
-an increase in income inequality, and much more.
Suffice to say Sri Lanka’s government will be challenged by myriad problems.
Continued spikes in domestic overnight rates forcing the CB to pump liquidity into the banking system suggest forex demand continued unabated through January. The CB will do very well to keep reserves flat. However, with a balance of payments deficit of USD 450 million a month and nothing in sight to plug this gap, following its current policy trajectory will see reserves will drop to USD 5 billion by May 2012, i.e. less than 3.5 times average monthly imports – a level deemed to signal a balance of payment crisis. It is a situation which neither the CB nor its government will wish confront with limited options and an external debt servicing burden set to climb from August 2012.
Sri Lanka needs to pay its bills and hard choices have to be made to conserve its forex reserves. Top among this to allow a free float of the rupee which the IMF believes will lead to a 20 percent devaluation. There is another and it involves entering into a bilateral/multi-lateral debt obligation(s) with a ‘friendly’ country(s). However, with it will come compromises which are not economic but political and geopolitical in nature.
How this will sit other countries who believe they have interests in Sri Lanka is an altogether different question.