Sri Lanka expected global shock to slow credit: CB Governor

Apr 16, 2012 (LBO) - Sri Lanka expected a global slowdown to moderate credit in the second half of 2012 and did not tighten monetary policy but spent foreign reserves to maintain growth, a top official said.

Sri Lanka's central bank, which runs a so-called soft-pegged exchange regime triggered a balance of payments crisis from mid 2011 by failing to raise rates when credit growth picked up partly due to a losses at state enterprises, which were manipulating energy prices.

Central Bank Governor Nivard told reporters that economists at the bank expected a global slowdown to also hit Sri Lanka.

"Well there we are human beings," Cabraal said. "The same way you might also have a view our view was very clearly that would be moderation, particularly taking into consideration the world situation that was taking place.

"And we thought world conditions were so harsh that the Sri Lankan economy will see a downturn and credit growth would diminish.

"But the growth momentum was strong was very strong at the time. It is still very strong. Even in February we have seen that the growth momentum is still strong."

Sri Lanka's foreign reserves fell from a peak of 8.1 billion US dollars in July to around 5.6 billion US dollars in mid March as the central bank sold down reserves and sterilized the sales by printing money to keep rates down.

Reserve Risk
Sri Lanka sterilized the balance of payments amid warnings from both the International Monetary Fund and other analysts not to do so.

But Cabraal said that the central bank had collected large volumes of reserves, equal to about six months of imports to be able to spend them when necessary.

"If you have six months of (imports) of reserves I do not see any need to protect it at six months and sacrifice your growth," he said.

"Now that is where some people may not really agree. But what is the use of having six months of reserves if you do not use it to preserve your growth momentum also?

"It is like saying, 'I have all these savings, and my child meets with an accident, I will keep my savings and not deal with the child'.

"What we have done is, we have utilized a part of the reserves that were in excess of what we needed, and we have sued a part of that to ensure that stability is maintained for a longer period."

Other analysts and economists have however warned that Sri Lanka and other countries that get into balance of payments crises are simply victims of flawed monetary regime, built by interventionist economists in the middle of the last century.

Flawed Regime

After the Second World War soft-pegged exchange rate regimes were build worldwide to create the Bretton Woods system.

Many hard pegged regimes (where monetary policy always adjusted to the exchange) were abolished in favour of soft pegs where policy makers were given tools to sterilize the balance of payments in a bid to control both the exchange rate and interest rates.

However two decades later the system collapsed due to the inevitable conflict between monetary and exchange rate policies, and so-called advanced nations went to floating rates where the monetary policy was allowed to determine the exchange rate.

Critics have said that larger the reserve buffer, the bigger the potential danger to the economy as corrective actions are delayed.

When corrective actions are delayed, eventually there is capital flight, which soft-pegged arrangements are simply unable to cope with and the entire economy tanks.

"Each of the major international capital market-related crises since 1994—Mexico, in 1994, Thailand, Indonesia and Korea in 1997, Russia and Brazil in 1998, and Argentina and Turkey in 2000—has in some way involved a fixed or pegged exchange rate regime," Stanley Fischer, a former managing director of the IMF said in 2001.

"At the same time, countries that did not have pegged rates—among them South Africa, Israel in 1998, Mexico in 1998, and Turkey in 1998—avoided crises of the type that afflicted emerging market countries with pegged rates."

Sri Lanka however had so far managed to avoid capital flight.

Sri Lanka's central bank however has persuaded most foreign investors into rupee denominated government bonds to wait patiently until corrective action has been taken.

The Central Bank has said that it will end all interventions in May. Analysts have warned that until all interventions are ended, and all Central Bank Treasury bill purchases are ended, the rupee is vulnerable.