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Economy in Catch 22 situation: ‘Managed float’ of dollar as prices of imports rise
The Central Bank (CB) has put the brakes on falling foreign exchange reserves, exacerbated by a surge in consumer spending including on motor vehicles in recent months, by allowing a free-float of the US dollar but raising fears that this could spike inflation.
With US dollar reserves falling as imports rose, the CB signalled to money market dealers on Friday that the dollar would be allowed ‘a free float’ and less intervention — mainly to protect the rupee from crashing — by the banking regulator. The dollar was expected to trade between Rs. 137 and Rs. 139 next week with the CB not allowing it to move beyond that range.
Motor vehicle dealers said the move would increase the prices of small cars by between Rs. 100,000 and Rs. 150,000 and luxury cars by Rs. 200,000 and Rs. 250,000. Essential consumer imports could also cost more and raise inflation levels, importers said.
“It’s a Catch-22 situation. A strong rupee against the dollar helps reduce the import cost of essential goods but weakens export earnings and foreign reserves. On the other hand a weaker rupee strengthen export earnings and reduces dependence on foreign reserves but could increase the prices of imported essential goods like fuel, sugar and wheat flour,” one banker said.
Latest CB data showed that Sri Lanka had spent (or lost from its foreign reserves) at least US$ 700 million in 30 days with reserves at $ 6.8 billion at the end of July from $ 7.5 billion at the end of June.
On Friday, as a result of the developments, the dollar gained by 3 per cent (according to news agency reports) from 134+ rupee per dollar on Thursday to a high of Rs. 139 + but ended the day lower at Rs 137+. The CB intervened closer to the end of day’s trading pumping in dollars to reduce the demand and stabilise the local currency. This meant it was not a free float decision after all but a ‘managed float’.
“What the Central Bank did was right and I believe it will intervene if the dollar goes over Rs. 138 or Rs.139 (to ensure essential imports don’t become too costly and unbearable),” noted eminent economist Dr. Indrajit Coomaraswamy, also chairman of economic think-tank the Pathfinder Foundation (PF). He said the Government had been spending massive sums of dollars to defend the rupee since mid-2014, hampering export earnings and eating into foreign earnings or borrowed foreign cash (loans and bonds).
More cash in the hands of the middle class through a wage hike for public servants and lowering of consumer prices of essential goods, has led to a sharp rise in car imports, particularly small cars, and non-essential consumer imports deepening pressure on foreign cash reserves. At the same time the CB has been defending the rupee by pumping in dollars (from foreign reserves) in the money market as demand rose to feed hungry consumers.
Motor vehicle dealers said the waiting list for particularly small cars had risen sharply drawing concerns even amongst the trade that increasing traffic jams in the city were due to the rise in the entry of new vehicles in the past 6-8 months.
Friday’s developments came on the back of the end of general elections and a CB statement earlier in the week expressing concern over the rapid increase in consumer goods including motor vehicles in recent months. Election-targetted goodies by the new Maithripala Sirisena-Ranil Wickremesinghe Government earlier in the year coupled with a salary hike led to huge spending but the Government was restrained in depreciating the rupee (to curb imports) as it would have impacted on the election result.
Car dealer Ashok L. Ganwani, Director of Lekhraj Automobiles (Pvt) Ltd, said finance companies would now increase their lending rates, with a consequent drop in customers, as they could no longer afford to lease a car. With the devaluation of the Sri Lankan rupee against the dollar, he believed car imports would fall.
The biggest challenge to Sri Lankan administrators in recent years has been to increase the savings habit when people have more disposable income. On the other hand efforts last year to reduce interest rates and stimulate investments by the private sector which then would increase productivity, create more jobs and generate more money for people did not happen as political uncertainty curbed investment trends.
This year, rather than save extra income which came from rising wages and reduced consumer prices, many Sri Lankans with extra, disposable income resorted to spending their money, buying vehicles and non-essential consumables plus take holidays and overseas trips. Credit card companies and retailers cashed in offering huge discounts and borrowing at zero interest.
This is also seen in the CB data which showed that credit disbursed by banks and lending institutions increased by around Rs. 55 billion in June while on a cumulative basis, credit increased by around Rs. 205 billion during the first half of 2015 compared to a decline of Rs. 53 billion during the corresponding period in 2014.
The former regime’s unviable strategy of borrowing dollars to beef reserves (through bonds and loans) to service debt and keep consumer prices down has been followed, to some extent and rather reluctantly, by the incoming January administration as payments were rising and election pressure led to the more money/cheaper goods tactic.
The ‘free float’ decision on Friday was also helped by the CB this week receiving the full $1.1 billion amount from the Reserve Bank of India (RBI) under a currency swap signed in July 2015 which will enhance foreign reserves here.
However, this is also borrowed cash and on the medium to long term not viable options, naturally prompting concern on this strategy by economic think tanks. “The present strategy of borrowing (including the Indian swap arrangements) and defending the exchange rate by depleting resources is unsustainable,” said the PF in a statement this week.
“The combination of a deteriorating balance of payments and defence of the rupee with external borrowing, including swap arrangements, is unsustainable. This needs to be addressed with some stabilisation measures, especially in the current uncertain global environment,” the statement said.
At an economic discussion organised by Marga Institute on Monday, Dr. Coomaraswamy explained his institute’s rationale in urging a new IMF package to provide financing to reduce the burden of short-term stabilisation and also boost sentiment in global markets at a time when Sri Lanka is vulnerable.
“We need IMF support very fast which would help reduce the burden of debt service. The IMF will also help good housekeeping and get foreign investor confidence back on track,” he said, adding that the IMF today is different and no longer overly preoccupied with austerity measures. It has a greater focus on growth and distributional issues, he said.