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Prof. Lalith Samarakoon: As US interest rates rise, no space for
Sri Lanka to wait and seeMarch 16, 2015Two contrasting developments
associated with USA and EU
Two contrasting developments are now taking place in the global
monetary arrangements. On one side, US Federal Reserve, known as
the Fed, which had introduced an unconventional monetary stimulus
called quantitative easing or QE from around end-2008 is planning
to gradually withdraw it from June 2015. On the other side,
European Central Bank or ECB, in desperation of the failure to
arrest slow economic growth and rising unemployment, has introduced
QE in the Euro area.
These two regions account for nearly a half of the global output
and are well connected to each other as well as to the rest of the
world through trade, finance and exchange rate arrangements. Hence,
the rest of the world cannot just sit and watch what is happening
in an important part of the global economy.
It specifically applies to Sri Lanka which has been a side
beneficiary of the Feds QE by attracting high interest seeking US
investments into its government securities market. This is the view
expressed by the Sri Lankan born academic, Lalith Samarakoon,
presently Financial Economist and Professor of Finance at the
University of St. Thomas in USA through email correspondence with
this writer as well as the conversation he had with him on the
Facebook.
Samarakoon in the late 1990s and early 2000s supported the Central
Bank to train its fund managers attached to the Employees Provident
Fund in its modernisation phase.
QE differs from OpenMarket Operations
Under QE, the Fed started to pump money into the US economy by
buying securities from the market in specified quantities. This
differs from the normal monetary policy adopted by a central bank
known as Open Market Operations or OMO wherein it would buy and
sell securities to regulate the excess liquidity in the market. QE,
in contrast, is one-way and supplies funds to the market on a
permanent basis through a pre-announced program of buying
securities.
The result of such a program is twofold: it increases the prices of
securities lowering interest rates and pumps new money into the
system increasing the countrys monetary base the quantum of seed
money available to commercial banks for lending to people by
creating multiple deposits and credit. The lowered interest rates
and multiple level of credit created in the economy are expected to
increase the total demand called aggregate demand inducing
producers to produce more. In the process, output and employment
are expected to move up taking the economy out of economic
recession.
US has attained QEtargets technically
Both these technical objectives have been realised by the US Fed.
Its monetary base which stood at $ 875 billion in August 2008 rose
sharply to $ 4139 billion by the end of January 2015. The benchmark
10 year US Treasury securities rates fell from 4.76% as at January
2007 to 1.91% by January 2012. An unintended consequence of the
interest rate decline in the US market was the flight of US savings
out of the country in search of better interest return
elsewhere.
Sri Lanka which had faced a chronic balance of payments problem and
depletion of foreign reserves quickly capitalised on these low
interest rates and allowed foreigners to invest in government
Treasury bills and Treasury bonds which had offered substantially
higher rates than those prevailing in US markets.
Accordingly, foreign funds flew into Sri Lanka and, by end February
2015, a total of $ 3.5 billion had been invested by foreigners in
government securities. According to an announcement made by US
Ambassador to Sri Lanka in February 2013, a bulk of these
investments had been of US origin. (available at:
http://www.sundaytimes.lk/130210/columns/iran-style-economic-crisis-cwealth-summit-in-balance-32552.html).
The total of such foreign funds in the government securities market
amounted to nearly a half of the countrys foreign reserves of $ 7.2
billion as at end-January 2015.
Bernankes justification of QE
The former Chairman of the Fed, Ben Bernanke, delivering the Josiah
Stamp Memorial Oration at the London School of Economics in 2009,
explained the rationale behind the Fed following QE (available at:
http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm
). According to him, the proximate reason for the financial crisis
was the housing sector bubble that had developed in the US but it
was an unintended consequence of the low interest rate policy
pursued by his predecessor, Alan Greenspan.
When the bubble burst in USA, it soon became a global crisis. The
heavy toll it took in terms of loss of output, employment and
wealth throughout the globe has therefore been substantial. Though
the global economy was expected to recover on its own in due
course, the timing and the speed of recovery were not to the liking
of the world community. Therefore, the governments intervention to
accelerate the process was called for. Bernanke believed, as he
explained in the Stamp oration, that the US Fed still had powerful
tools at its disposal to help the US to come out of the financial
crisis and economic downturn.
One mistake leading toanother mistake
The underlying assumption of this type of policy intervention by
the Fed, and also by other central banks, is that central banks, or
more specifically the central bank created-money, can boost
economic growth.
The reasoning goes as follows: Economic growth comes from the
production of a bigger output and continued production of such a
bigger output is dependent on the consumers ability to buy that
output on the one hand and producers ability to produce more and
more output on the other. When central banks reduce interest rates
artificially to low levels, it is believed that consumers make a
hard choice in favour of consumption and producers in favour of
investments. So, central banks seek to kill two birds with one
stone by reducing interest rates. But the reduction of interest
rates also leads to shrink the savings flows since people now get a
low rate of return on their savings.
When the savings flow declines, banks are unable to lend money to
businesses despite the fall in interest rates. To increase the
fund-available for lending, central banks start printing money and
supplying to the financial institutions. It drives the interest
rates further down and dries up savings flows further. Thus,
central banks get caught in a vicious trap: They have to keep on
pumping more and more central bank-printed money to the financial
system in order to keep it alive. Thus, one mistake made by a
central bank leads to the making of a series of mistakes.
Unexpected fall in USmoney multiplier
With this type of money creation, the US would have ended up with
an uncontrollable hyperinflation but it had been saved by an
unexpected market development. Banks which had already been hit
once by the crisis had been cautious about lending and therefore
had kept the new money in the form of excess liquidity temporarily
deposited with the Fed.
The result was a drastic reduction in money multiplier the number
of times a given unit of monetary base is increased by a bank in
creating multiple deposits and credit. Thus, the US money
multiplier which stood at 5 meaning one dollar created by the Fed
will eventually end up as 5 dollars in 2008 fell to a level of less
than 1 by end 2013. Thus, for the first time, the US monetary base
has been bigger than its narrow money stock. It is a blessing in
disguise since the Feds QE has not led to monetary expansion and
consequential high inflation.
As a result, the US citizens now experience the historically lowest
inflation which is below 1%. However, it has inflicted the US
economy with a number of macroeconomic ailments: Low inflation,
high trade deficit, low economic growth, high unemployment and
pressure on the dollar to fall in the international markets. Thus,
it appears that Bernanke, having tried to solve one problem, has
created so many problems in the US economy.
US has no choice but togive up QE
These ailments take the form of rising interest rates in order to
curb inflationary pressures, ending the current QE since the Fed
will not be able to continue with liquidity pumping at the same
rate and a massive shrink of consumption by US citizens and
investment by businesses. It will lead to a curtailment of the
output in USA; it will also have adverse impact on several other
countries which are linked to the US economy and its financial
system.
It has now been the task of Bernankes successor, Janet Yellen, to
reverse the earlier easy money policy pursued by the Fed. According
to the latest reports, the Fed is now seriously considering the
tightening the US monetary policy beginning from June 2015
(available at:
http://www.wsj.com/articles/fed-leans-toward-removing-patient-promise-on-rates-1426014812).
In expectation of this move, the 10 year US Treasury securities
rate accelerated from 1.91% in January 2012 to 2.86% by January
2014. It is therefore likely that the US interest rate structure
will move to a higher plateau within the next six to 12
months.
With a new QE being implemented by the European Central Bank at
present, funds are expected to move from Europe to USA searching
for higher interest rates. As a preliminary for this move, Euro is
now falling against the dollar reaching a level of $ 1.05 per Euro
as on 12 March. The equality between the two major currencies in
the world is expected to take place pretty soon.
Prof. Lalith Samarakoon:Dont just sit and watch the global
developments
Samarakoon says that policy makers in Sri Lanka as well as in
emerging markets should take serious note of these developments.
Though the magnitude and duration of US interest rate increases are
not known, it is likely that it would take place in a slow and
measured phase. At the same time, the decline in oil prices has
delivered a positive shock to oil importing emerging economies like
Sri Lanka. In that context, according to Samarakoon, these
countries have been driven to an unchartered territory making it
necessary to predict the net impact as early as possible.
Samarakoon has identified some of the net effects: The first to be
affected are the capital markets. Some of the foreign portfolio
investments, particularly the hot money that came to emerging
markets and Sri Lanka in search of higher yields and returns into
the government bonds and stock markets are likely to reverse
gradually as investors find acceptable yields in the US which is a
much more stable and liquid market
Further, he says: The cost of dollar-based funding will go up and
the policy makers must factor this in their desire to float more
government bonds in international markets. Definitely, given the
drop in Euro and the euro-based interest rates, the government
needs to be proactive to diversify its funding sources.
What Samarakoon says is that Sri Lanka should not postpone the
issue of the sovereign bonds in the international markets because
US interest rates are to rise after June and EU rates have already
fallen. Hence, the proper policy is to make hay while the sun
shines.
Need for having a credible domestic bond market
The global developments have shifted the focus to domestic markets.
Argues Samarakoon: The domestic capital market conditions and
investors will become more important for government financing. The
viability and credibility of domestic bond markets become ever so
significant. In that context, liquidity in the domestic fixed
income sector is critical. If the domestic liquidity also dries up,
then there is going to be more upward pressure on bond yield and
general interest rates. The monetary policy will need to be
carefully calibrated so as not to raise the interest rates abruptly
which will have larger and wide-ranging adverse economic
ramifications.
Given the current scandal eroding the credibility of the bond
market, Samarakoons assertion that its credibility should be
restored should be an eye-opener for Sri Lankas policy
authorities.
The problem does not end here. Capital reversals could also put
downward pressure, according to Samarakoon, on the exchange rate
creating a challenging environment for maintaining a fairly stable
exchange rate. Of course, the benefits of lower oil prices will be
partially offset by any potential currency depreciation. Hence, on
a positive side, lower rupee will benefit exports and to the extent
the US economy continues to show strength and ECBs QE program
raises growth in the Euro-zone countries, Sri Lanka will further
benefit from increased demand for its exports.
Samarakoon says that the decline in interest rates in EU area will
not increase hot money flows to Sri Lanka. That is because for
investors in EU, USA with its more liquid and free financial and
capital markets will offer better investment opportunities. Hence,
the developments in USA are to dominate the global scene more
strongly in the short to medium term.
Samarakoon: Central Bank should give right signals
In this scenario, how should Sri Lanka design its policies?
Samarakoon has several answers to that question. He says that in
the sort-run, the Central Bank and other policy makers will have to
prudently manage and balance any risks posed by capital flow
reversals, downward pressure on the exchange rate and upward
pressure on interest rates. Building a strong foreign reserve
position must be considered a top priority to mitigate the risks
against any negative external shocks. If external financing becomes
too costly and unviable, the domestic money and bond markets should
play a pivotal role in government financing.
But how could that be done? Samarakoon argues that The Central Bank
needs to provide right signals, market guidance and a transparent
policy framework to maintain interest rate stability since higher
interest rates coupled with low growth are to worsen the budget
deficits.
In this context, says Samarakoon, Sri Lanka should have a prudent
medium to long term fiscal policy framework that incorporates
serious revenue and expenditure reforms in multiple areas of the
economy. Ultimately, fiscal policy should provide adequate space
and flexibility for us to respond to adverse external and domestic
events without destabilising the economy and social safety network.
Such instability will ultimately lead to social and political
unrest, making any meaningful economic reforms more
difficult.
Negative economic shock should be properly managed
What is being delivered by USA and EU is a negative economic shock
to Sri Lanka. That shock has to be managed by the countrys Central
Bank and the two line ministries involved in the economy, namely,
Policy Planning and Finance, through a carefully laid down policy
package. This can be done not by increasing lavish expenditure but
by prudently managing such expenditure. This is the biggest
challenge presently faced by Sri Lanka.
Swap with RBI is good but support from IMF is better
Sri Lanka now faces the risk of the hot money mobilised by the
previous government flying out of the country without warning. Any
sudden depletion of foreign reserves will bleed the country to an
untimely death. It has been reported that the Central Bank has
entered into a swap facility of $ 1.5 billion with the Reserve Bank
of India to cushion its foreign reserves.
This is only a temporary measure and should not be relied on
permanently. A more permanent measure that would require Sri Lanka
to implement a comprehensive economic reform program, as argued by
Samarakoon, is a Balance of Payments support from IMF that is
contingent on policy reforms. Thus, the present negative external
shock is the ideal situation for Sri Lanka to present its case with
IMF which is, it appears, under a strange belief that Sri Lanka
does not need BOP support at the moment.
Hence, Sri Lankas policy, according to Samarakoon, should be
forward-looking and proactive. In that background, it has no space
for a wait and see approach.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of
Sri Lanka, can be reached at [email protected]); Lalith Samarakoon
is available at [email protected].)