Apr 05, 2012 (LBO) - Sri Lanka is reaching its foreign borrowing limit and interest rates may needed to be raised further to curb credit and cure a balance of payment crisis, a media report quoting Treasury Secretary P B Jayasundera said"Sri Lanka is reaching the limits on borrowing. The government itself has a $3 billion bond market," Jayasundera was quoted as saying by Reuters, a news agency.
"Given our size, reserve levels, export size, I would consider that's a kind of a ceiling.
"So we can't go for unlimited borrowing for external balances."
Sri Lanka ran into a balance of payments crisis in mid 2011 as state borrowings spiked due to losses in state enterprises amid strong private sector credit.
As part of the solution, foreign ownership of government rupee denominated debt was expanded and private entities were also encouraged to borrow abroad.
But foreign borrowings simply encourage more spending and imports by feeding a credit cycle rather than curbing it.
To keep the credit bubble and growth ticking, Sri Lanka had to resist an interest rate hike and allow the currency to depreciate, a move advocated by the International Monetary Fund. Depreciation however pushes inflation up and destroys real wages and savings.
The Central Bank instead sold dollars to keep the peg. Such 'non-sterilized' sales shortages and contracts the monetary base, pushing interest rates up and re-balancing the economy.
But Sri Lanka's central bank, like many so-called 'soft-pegs' sterilized the dollar sales with printed money giving fresh cash for credit and imports. Such sterilized sales of foreign exchange results in foreign reserve losses, need for more defence and new liquidity shortages.
The peg collapses when foreign reserves falls to levels that are not acceptable to decision-makers.
"Now the only way the liquidity can come is by slowing down loan demand and also by raising deposits," Jayasundera said.
"Both cannot be done, unless you raise interest rates."
Data from the Central Bank showed that liquidity was still disappearing from the banking system, which analysts say may point to 'off-market' dollar sales. However in April it is also usual for seasonal cash demand to go up, due to a traditional New Year festival.
The IMF this week gave 427 million dollars to boost Sri Lanka's reserves saying many corrective steps had been taken, including a 50 basis point rate hike and credit curbs.
Jayasundera said authorities should watch April data and raise rates by another 50 basis points. Sri Lanka raised its key reverse repo rate by 50 basis points to 9.00 percent in February but market rates have risen further.
He also talked up the rupee.
"I am pretty sure the exchange rate cannot go beyond 125 under our current economic fundamentals," he said.
Analysts say if credit is slowed and sterilized sales of foreign exchange are ended the rupee can rapidly bounce back.