ECONOMYNEXT - Sri Lanka's should be prepared to tighten monetary policy and raise more taxes to pay higher state worker salaries, and contain spending as economic imbalances and risks are widening, the International Monetary Fund has said.
"With the recent acceleration in private sector credit growth and rising core inflation, there is now little scope for further monetary easing," the IMF's executive board said in an assessment on Sri Lanka.
"Most factors—including the deterioration in the balance of payments and pressures on the rupee—suggest that the CBSL should be prepared to tighten monetary policy in the coming months, albeit at a gradual pace."
Sri Lanka's central bank has a penchant to print money, delay rate increases, generate balance of payments crises and run to the IMF. It is still repaying a loan from the lender, and the latest assessment involves post-program monitoring.
Loose Monetary Policy
This year the Central Bank cut rates despite rising private credit demand, and a budget that deteriorated sharply after January 2015 and then printed money outright to repay maturing government debt by rejecting bids at Treasury bill auctions.
Over the last two weeks, Sri Lanka's central bank seems to have ended its runaway debt monetization operations at least for the moment and appeared to be tightening policy by mopping some of the liquidity that had been created.
Treasury bill yields were also allowed to rise on Wednesday.
Sri Lanka had printed large volumes of money to finance the budget deficit and repay maturing Treasury bill over 2015. The new created money allowed banks to give large volumes of credit outpacing the deposits raise. The excess demand then hit the balance of payments as imports.
The central bank then had to mop up the money in forex markets by spending forex reserves to prevent the rupee collapsing further by spending forex reserves.
Rupee Pressure
The rupee has already collapsed from 131 to 143 to the US dollar over 2016. By mopping up the excess money through the so-called domestic operations, pressure on the currency and runaway credit and imports can be reduced.
IMF said a better budget and better monetary policy can help strengthen the external balance.
"Tighter fiscal and monetary policies could help restrict aggregate demand, contain the recent sharp rise in imports, and strengthen the external balance," the IMF said.
"However, to be more effective, these policies should be supported by greater exchange rate flexibility, reduced foreign exchange intervention, and efforts to deepen the foreign exchange market, as well as structural reforms to enhance competitiveness."
Analysts say at the moment there is no sterilized foreign exchange sales where dollars are sold and liquidity is subsequently injected to prevent rates rising, a problem which can be corrected by ending interventions.
The problem is with new liquidity created by central bank purchases of Treasury bills before intervention are made, which is why an attempt to 'float' the currency in September also failed and it simply fizzled out as a devaluation and currency defence had to resume.
A falling rupee would generate a bout of inflation, boost rupee tax revenues and help pay the salaries of state workers and subsidies by boosting nominal revenues.
Analysts say it would impose hardships on private sector workers and the self-employed who will find that their salaries and banks savings are worth less.
This year the current account deficit of the balance of payments would narrow despite non-oil imports rising, the IMF said. Oil import bill would fall.
Analysts had also said earlier that Sri Lanka's external currency account deficit would narrow if net foreign borrowings of the government, which is the key driver of the trade deficit (the largest component of the current account deficit) narrows significantly.
Stability
IMF's staff assessment said it was up to Sri Lanka's authorities to improve spending and monetary policy to bring stability back to the economy.
"The economic outlook remains uncertain, and will depend to a large extent on the course set for economic policies in the coming months," a staff assessment said.
"The risks are tilted to the downside.
With rising the IMF said Sri Lanka needed a better budget for 2016, the IMF said.
"In view of high public debt, fiscal developments this year pose a risk to the economy and call for ambitious measures in the 2016 budget to put Sri Lanka’s fiscal position on a more sustainable footing.
IMF said Sri Lanka's economic imbalances came with rise in state worker salaries and cuts in taxes of several goods including cars, when international conditions were also unstable.
A rise in US interest rates may lead to a further changes in the global economy, the IMF said.
"Despite continued access to international debt markets, these trends suggest that financial risks for Sri Lanka have increased," IMF said.
"To mitigate these risks, the authorities should take appropriate corrective actions to safeguard macroeconomic stability and lay the foundation for durable and inclusive growth.
"Improvements in the business climate, reform of state owned enterprises, and a more open trade regime are key to boosting competitiveness and growth."
