Dr. Harsha on rupee depreciation, balance of payment crisis and ongoing tug-of-war

If the Governor of Central Bank has an urge to enter politics, he should come to Parliament without playing politics inside the CB, charges United National Party Parliamentarian and well-known Economist Dr. Harsha de Silva.

Dr. de Silva notes that Governor Nivard Cabraal should respect the sanctity of the Central Bank and therefore if Cabraal desires getting into active politics, he should talk to President Rajapaksa and enter Parliament through the National List.

He further says that if the rupee is not allowed to depreciate to its actual value due to personal and other ego-related issues, the country will head into another balance of payment crisis. Dr. de Silva stresses that the longer the tug war goes on, the harder the adjustment is going to be.

Following are excerpts from the interview:

Q: The Central Bank Governor has said that he is looking for another IMF follow-up programme or a surveillance programme. How do you see this move, especially when Sri Lanka is already trapped in massive debts?

A: When Dr. Lalithasiri Gunaruwan presently at the University of Colombo wrote a newspaper article that Sri Lanka does not necessarily need this money and asked why the Government couldn’t move out of the programme, the economist community in the country started to discuss this matter. The discussion was that ‘if we have more than enough money, why do we need more money?’

The Central Bank Governor kept on reiterating that he had more than enough money and mountains of foreign reserves. But the consensus was that we needed those funds not purely for money but for discipline. We needed to meet certain targets, we needed to maintain budget deficits at certain levels and we needed to ensure that there was build up of net external reserves. Therefore, the framework brought in a sense of fiscal and monetary discipline to the policymakers. That is why the bailout package was more important than the money per se.

It is true the deficit numbers are there. But discipline in certain institutions such as the CEB and the CPC is no longer present. By 31 December 2011 the combined loss of CPC and CEB should have been zero; that was a condition included in the agreement.

The net international reserve is another massive problem. Although the Governor says his reserves are building, we should not forget that those are borrowed reserves.

The governance and discipline framework has already broken down. The issue between the Governor on one side and all the economists on the other side has to be mentioned here. Immaterial of party affiliations, we are all against the Governor controlling interest and exchange rates. However powerful the Governor is, he has to keep in mind that there are laws of economics.

Now, for all intents and purposes, the IMF loan is off. Instead of saying it is off, the Governor is saying we are looking forward for a follow-up programme or a surveillance programme. That is the truth.

Q: The IMF says it is willing to negotiate if the Central Bank allows currency flexibility. How will this be possible when the CB has already intervened in defending the rupee after the 3% devaluation in November last year?

A: The IMF during the previous loan taken during Ranil Wickremesinghe’s time was different to the IMF of today. That was pre-crisis and this was post-crisis. The IMF itself has evolved and the ways they look at problems are somehow much more flexible than previously.

At the previous time, they had a privatisation programme in the forefront. When Wickremesinghe took office, the economy was in an utter mess. We were negative and had no money. We needed the money from the IMF; therefore we had to agree to a whole lot of conditions. But post-crisis, the IMF has changed and they are willing to be flexible.

This is new thinking, a new way of engaging in business all over the world. But this does not mean that the IMF is willing to be flexible on fundamental issues. For instance, IMF money is to ensure that countries don’t fall into a BOP crisis. So after having taken IMF money, if a country is diving headfirst into a balance of payment crisis, the IMF is not going to be flexible on that.

IMF money was not brought to build bridges and roads; that money is there to ensure that there is sufficient money to repay foreign loans and to deal with issues like that.

If we are again saying ‘please give us a lifeline,’ the Government will have to agree to fundamental economic requirements.

Meantime, let me also stress on the fact that what the Governor is doing is wrong. Most economists in this country are saying this in one voice. I had this discussion in Parliament at the Consultative Committee meeting twice with President Rajapaksa, with the Governor in attendance.

I showed a chart to the President and said Sri Lanka’s export competitiveness is falling. One reason for this was because our exchange rate policy was wrong. Both times when the President inquired from the Governor about my arguments, the Governor denied it.

Having a wrong exchange rate is completely anti-‘Mahinda Chinthana,’ because the ‘Mahinda Chinthana’ is to ensure growth and development of local industries. Growth and development of local industries can happen in two ways: exporting what we produce and producing goods that are more competitive than imports. But with an overvalued rupee, foreign imports become cheap and as a result the local industry is getting hit.

This intervention is not healthy; this is forcefully keeping the rupee at an artificial level. They intervened so much and according to various calculations they have lost close to 2.5 billion dollars up to now, including over 700 million dollars since the devaluation took place.

Now the Governor says he can hold it as long as it is necessary. The Governor thinks it is some challenge. This is not a personal ego trip. This is not a fight between Nivard Cabraal and P.B. Jayasundera or Cabraal and Koshi Mathi or Cabraal and Harsha de Silva. It is our country we need to worry about.

In accounting, there is a set of rules and one can’t change those rules. But economics is not like that; economics is an art too. In economy, one has to have to be able to understand the changing world. We have to understand that Sri Lanka itself is changing.

Running a Central Bank needs profound thinking; it is more than accounting. The Governor is not God; the Governor is the Governor. His actions are dictated by the laws of economics; economics is not going to be dictated by the Governor. He can never hold this; the rupee will depreciate. The longer Cabral holds the rupee at 114, the harder the fall is going to be.

Q: Are you saying Nivard Cabraal has failed as the Central Bank Governor?

A: I would never say that Cabraal has failed as the Governor. Cabraal has done a good job in controlling inflation. I commend him for that. People think I have a personal clash with Cabraal, but there is nothing like that. However, I am completely not in agreement with his exchange rate management. Cabraal has failed with governance, particularly with the EPF.

Q: When launching the Central Bank roadmap for 2012, the Governor said that he is expecting 8% growth for this year, which is less than 8.3% projected in 2011. How possible is this?

A:This is a global matter; Europe is not growing and United States is growing slowly. Even though we don’t accept it, Sri Lanka depends on the West for our growth. Therefore, when West falters, we will have to face certain issues.

Besides, given the surge after the war and the slow growth in the prior time period, to sustain 8% growth is difficult. We need investments in order to achieve this. That is where the Government is shooting itself in the foot. If we need to achieve 8% growth, we need more and more investments coming in, but where are the investments?

Even the much much-hyped Shangri La project has not been initiated. The project has to be completed by June 2014. If the project is not completed by that time I will initiate action for it to be taken over under the Underutilised Asset Act. The Government said Sheraton would invest in Sri Lanka, but Sheraton issued a statement saying they were not aware of such deal.

Q: In the Central Bank Roadmap, inflation is expected to be maintained at 5-6% in 2012. What are your views?

A: There are a few things that are happening; one is the continuous change of the basket. For instance, there is substitution taking place at household level. A person who buys fresh fish will stop buying fish due to rising prices and start buying canned fish. Then his expenses will slightly drop. In such a situation, the Government cannot claim inflation has come down.

Meanwhile, alcohol and tobacco have been removed from the choice basket. The Government can’t remove goods from people’s basket and then say inflation is under control. There are such technical issues.

Inflation is a monetary phenomenon. If the Central Bank controls growth of money supply, then they can control inflation. But when there is high credit growth, things will be slightly difficult. If the economy begins to overheat, the Central Bank will have to be able to control it. If they continue to keep interest rates also low, that will fuel further credit growth, which will have an impact on inflation. It is not that easy to have inflation at 5-6%, but it is not impossible either.

Q: Sri Lanka is heading toward a balance of payment crisis with reserves declining to US$ 6 billion in December from US$ 8 billion in July last year. How do you see this situation?

A: We are creating a balance of payment crisis. Sri Lanka is having the largest-ever deficit in the trade balance, which is close to US$ 8 billion already. Never have we ever seen such a difference between exports and imports. This means that we are importing US$ 8 billion of imports more than we export on the trade account.

One reason for this is the disequilibrium in the exchange rate. One way the market can correct this is let the exchange rate adjust, so that exports will increase and imports will fall. For some external reason if that rupee adjustment is not allowed to take place, the only way we can do it is by selling dollars. Then there is a high demand for dollars and the price of dollar will go up.

What the Governor is doing is that; to keep the dollar prices down, he is giving our external reserves out to the market. In July we had US$ 8 billion in reserves and it came down to US$ 6 six in December last year. Of that six billion, what we really own might be less than two billion and the rest of it is not ours.

When we sell dollars into the market, people buy those with rupees and then the amount of rupees in the market falls. Then the interest rates go up. This is fundamental economics. But the Government doesn’t want the interest rates to increase. Then to keep the interest rates down, the Government has to throw rupees back into the market. To do that, the Central Bank has to buy Treasury bills from the market and in return for that we put money back into the market.

This is called sterilised intervention. It is the recipe for a balance of payment crisis. This is the issue we are facing. We can see the build-up of Treasury bills in the Central Bank’s books. The more Treasury bills build up in the Central Bank books means more money is printed into the market.

The exchange rates are at 114 and interest rates are low. This means that credit will grow and as a result the import demand grows. Then we will import even more, and then it will create even greater pressure on the exchange rate because the exchange rate is wrong and exports and not growing.

This circle is a vicious one. At some point one of these two will have to give; either the interest rate will have to increase or the exchange rate will have to be depreciated. Unless we do that, we will further the coming balance of payment crisis.

Q: While Governor Cabraal continues to defend the rupee, Treasury Secretary P.B. Jayasundera stresses the need to maintain flexible exchange rates and tighter monetary policy to discourage imports. How do you see two key position-holding officials in the Government having two different opinions?

A: I am an economist and I have to go with the economist. I see P.B. Jayasundera’s logic. All economists in the country will agree on this matter; the rupee must be more flexible. I don’t know what is holding Cabraal; whether it is personal pride or some other reason.

I would like to invite Cabraal to Parliament and then he can do politics there. Cabraal is playing politics inside the Central Bank and he shouldn’t do that. If he has the urge to become a politician, he can talk to President Rajapaksa and come on the National List to Parliament.

Cabraal should respect the sanctity of the Central Bank. It is an independent organisation and not for politicians. This entire tug-of-war is a political one between the powerbrokers themselves.

Q: How will the tug-of-war between the Central Bank Governor and Treasury Secretary affect the country politically and economically?

A: If the rupee is not allowed to depreciate to its actual value due to personal and other ego-related issues, then the country will surely dive headfirst into another balance of payment crisis. We will have to either let the rupee float or increase interest rates. The longer this tug-of-war goes on, the harder the adjustment is going to be, because the adjustment will have to happen.