Treasury Secy. says need further monetary tightening

COLOMBO (Reuters): Sri Lanka’s central bank will have room to raise interest rates by at least another 50 basis points if April trade and inflation data show signs of stabilizing, the treasury secretary said on Wednesday.

“Since we have already raised policy rates by half a percent (in February), maybe another 50 basis points upward revision could stabilize the whole macroeconomic environment,” P.B. Jayasundera told Reuters in a rare media interview a day ahead of the central bank’s next policy-setting meeting.

“Right now is not the time. We must wait for the April data and look at the adjustments that have taken place, and then take a policy decision that will maintain the compatibility of the interest rate and the exchange rate.”

Preliminary figures for April should be available to policymakers by early May.

Sri Lanka’s trade deficit rose to nearly $966 million in January from a year earlier as global demand for Asia’s exports weakened and as higher oil prices swelled its oil import bill.

Annual inflation, meanwhile, accelerated to a six-month high of 5.5 percent in March, well above analysts’ expectations and amplified by a weak rupee and fuel price increases.

The island nation posted a record trade deficit of $9.7 billion last year, prompting the central bank to abandon increasingly costly attempts to intervene in foreign exchange markets to support the sliding rupee, moves which were heavily depleting the country’s official reserves.

The rupee hit a record low of 131.60 to the U.S. dollar on March 19.

It has since rebounded by more than 5 percent to around 125, but has still depreciated by around 8 percent since the central bank stopped defending it on February 9.

Jayasundera said the currency has now bottomed out, and should not weaken again past 125 under current economic conditions.

Some market watchers had speculated the currency would depreciate by more than 20 percent after the central bank moved to a more flexible exchange rate policy, he noted.

Meanwhile, heavy dollar sales by the central bank have tightened liquidity in financial system, he added.

“That liquidity compression needs to be eased up. Now the only way the liquidity can come is by slowing down loan demand and also by raising deposits. Both cannot be done, unless you raise interest rates.”

The central bank’s decision to move to a more flexible exchange rate came after it spent more than $2.7 billion in the second half of 2011 in abortive attempts to halt the rupee’s slide.

Its frequent interventions in currency markets incurred the wrath of the International Monetary Fund (IMF), which delayed payment on part of a $2.6 billion loan that it had extended to Colombo to help the country avoid a balance-of-payments crisis.

The IMF this week approved that payout, citing the central bank’s move to a more market-oriented exchange rate policy, and the final installment of the loan is expected to be released in a few months.

“Even when the central bank stays out, it (the rupee) is not going to be over 130,” the treasury secretary said.

“I am pretty sure the exchange rate cannot go beyond 125 under our current economic fundamentals.”

The change in exchange rate policy has already helped to save around $600 million in February and March alone, while the government’s decision to raise motor vehicle taxes over the weekend will prevent another $700 million of outflows which had been expected this year, Jayasundera said.

Jayasundera also warned about the country’s reliance on foreign borrowing.

Sri Lanka in the past has posted a balance-of-payments surplus through external borrowing. It has already borrowed $3 billion through four sovereign bonds and more than $2 billion through selling government securities.

“Sri Lanka is reaching the limits on borrowing. The government itself has a $3 billion bond market. Given our size, reserve levels, export size, I would consider that’s a kind of a ceiling,” said Jayasundera, who has been the main architect of the island nation’s budget in the past two decades.

“So we can’t go for unlimited borrowing for external balances,” he said.

Since February, the central bank has kept its repurchase rate at 7.5 percent and its reverse repurchase rate at 9 percent, while urging banks to limit annual credit growth to 18 percent to reduce the risk of the economy overheating.

The IMF said on Tuesday the economy had not gone into overdrive, but cautioned there were signs that bore watching, such as increases in credit and imports.

After the February rate hikes and change in exchange rate policy, the government also raised fuel, electricity and transportation prices to cool demand-side pressures.

That prompted the central bank to lower its 2012 economic growth target to 7.2 percent, from 8 percent.

 Jayasundera said annual inflation will average around 6-7 percent despite the price adjustments.