US rate hike has local repercussions
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The US Federal Reserve (Fed) has raised interest rates terminating its near-zero rate policy that was launched seven years ago in the aftermath of the worst global financial crisis experienced ever since the Great Depression. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Fed decided to raise the target range for the federal fund rate to 0.25 – 0.50 per cent effective from 17 December 2015. The Fed has indicated that more rate increases will come with gradual adjustments in its monetary policy stance.
When the US sneezes, emerging markets catch a cold. That is a fact.The United States, being the major source of global capital, any action by the Fed usually creates ripples in the financial markets. The impact will be felt mostly by the emerging market economies like Sri Lanka due to the shift of foreign capital from such volatile economies to less-risky investments in the US.
Specifically, the US rate hike will have greater adverse repercussions on emerging market economies which are handicapped by weak macroeconomic fundamentals and unfinished reform agendas. Sri Lanka is no exception in the context of its upcoming inflationary pressures, declining foreign reserves, prolonged fiscal imbalances and reform failures.
Ill-effects of Sri Lanka’s relaxed monetary policy
unbearable
Since 2012, the Central Bank (CB) has adopted a more relaxed monetary policy stance by reducing its policy rates from time to time so as to boost economic activities. Accordingly, CB’s Standing Deposit Facility Rate or SDFR (rate applicable for placement of overnight excess funds of commercial banks) now stands at 6 per cent, and the Standing Lending Facility Rate or SLFR (rate applicable for lending of overnight funds to commercial banks) at 7.5 per cent. Moreover, the Statutory Reserve Ratio or SRR (percentage of deposit liabilities of commercial banks required to be kept as a cash deposit with CB) was brought down from 8 per cent to 6 per cent in May 2013.
In an unusual move, directives have been issued to commercial banks and other financial institutions stipulating the ceiling interest rates for their deposits. These directives still remain applicable.Whilst keeping the interest rates low, the CB had defended the exchange rate by releasing dollars to the market during the last few years. These two contrasting policy stances have led to create demand pressures as currently reflected in rising inflation, high imports and declining foreign reserves.
As I have repeatedly mentioned in these columns, targeting low interest rates and stable exchange rates side by side is an impossible task, since a part of the excess demand propelled by low interest rates shifts to imported goods thus widening the trade deficit and draining foreign reserves, and ultimately calling for exchange rate depreciation.
Monetary tightening kicks off
Now, the CB has begun to tighten monetary policy in the background of the above domestic imbalances and the contagious effects of the US rate hike.The CB has increased the SRR by 1.50 percentage points to 7.50 per cent effective from 16th January. This measure is expected to reduce market liquidity.
The CB, however, has not changed its SDFR or SLFR, and they remain unchanged at their current levels. Nevertheless, the CB is likely to consider raising these rates in time to come to deal with the aggravating economic imbalances in the midst of high borowing costs abroad. Thus, a rise in domestic interest rates in the near future could be anticipated.
Costlier and less accessible foreign borrowings
Sri Lanka and other emerging markets are bound to lose the hitherto enjoyed luxury of easier access to low-cost foreign capital due to the rate hike by the Fed. Since higher rates are offered to US bonds now, investors will pull out their capital from emerging markets to invest in more stable US securities. Hence, emerging market economies will find that foreign borrowings are not only expensive but also less-accessible.
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Meanwhile, the increased foreign capital inflows to the US results in an a countries like Sri Lanka which already have high foreign debt denominated in dollars.Larger amounts of domestic currencies will have to be spent to purchase dollars to meet the debt service payments. As a result, Sri Lanka’s budget deficit for 2016 is likely to exceed the target of 5.9 per cent of GDP, which is already non-achievable due to the reversal of many budget proposals. The strengthening of the dollar also leads to a rise in import costs worsening the balance of payments and accelerating inflation.
leaner domestic bond market essential
In view of the rising foreign borrowing costs and tighter global capital markets, it would be prudent that the domestic capital market is increasingly mobilized to meet the borrowing requirements of the government to finance its ever expanding budget deficits. This calls for a vibrant and transparent domestic bond market. Although the local bond market has expanded over the years, there are pitfalls in the system as implied by the alleged scandal reported not so long ago. The bond market will have to be elevated to international standards with best practices. The bidding system should be changed from the current cartel-type practice to a transparent bidding system with wider public participation.
(The writer can be reached t sscolom@gmail.com)