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Rupee float unlikely to fix BOP crisis, interest rate hike needed
* Growth - inflation trade off emerges
Floating the rupee may not be of much help to fix the balance of payments crisis leaving the Central Bank no option but tighten monetary policy interest rates by a further 75 basis points this year in order to curb credit demand. The bank also faces the prospect of having to make a tough choice between growth and inflation, suggests a new research paper released by Standard Chartered Bank yesterday (Feb. 22).
"The sensitivity of import growth to the exchange rate has been relatively modest over the past five years, data shows. Import growth appears to be more sensitive to global and local dynamics than to changes in the exchange rate. Given that we expect USD-LKR to peak at 119 in Q2-2012, we assume that a substantial drop in import growth as a consequence of LKR depreciation is unlikely. So to avert a BOP crisis, a two-pronged strategy of weakening the currency and raising policy rates is required," said the research papers authors Samantha Amerasinghe and Nagaraj Kulkarni.
"The domestic economy is also still showing signs of growth. The sharp rise in imports of investment goods for ongoing infrastructure projects, which grew 64% y/y in January-November 2011, is indicative of this. As a proxy for import-related credit, we add consumption credit (most of the consumption items bought on credit are imported) to import trading credit. Together, they constitute about 30% of overall credit and were growing at 34% as of end-2011. To reduce overall credit growth to 16% (the central bank’s end-2012 target), growth in both import-related credit and other types of credit related to domestic economic activity needs to be curbed substantially.
Modest LKR depreciation and marginal rate hikes might not be enough to effect such a sharp slowdown in credit demand; such a slowdown would in turn impact growth with a lag.
"If GDP growth starts to slow sharply, the central bank may be less determined to bring credit growth down to the 16% target, which may be indicative in nature. In that case, the CBSL is likely to tread the middle path – moderating credit growth from very high levels but not strictly enforcing the 16% credit growth target, while ensuring that GDP growth prospects are not jeopardised. Our baseline scenario factors in two further rate hikes of 50bps and 25bps in 2012, but we will review this call depending on how quickly credit demand responds to changes in interest and exchange rates. The timing of the hikes will be contingent on two factors: the inflation trend in Q1-2012 and credit growth. If inflation rises or credit growth remains elevated, this could accelerate hikes. Historically, during tightening cycles between 2006 and 2010, the CBSL did not hike rates more than 125bps. However, any change in assumptions on inflation drivers could reduce the number of expected rate hikes for the rest of 2012," the SCB research paper said.
"Aside from addressing high credit growth, the central bank must also face a trade-off between inflation and growth. While the CBSL has maintained its 2012 growth forecast at 8.0%, we have revised down our forecast to 7.1% due to the uncertain global growth outlook, the tighter monetary policy stance and higher oil prices.
"The CBSL faces a policy dilemma arising from downside risks to growth, upside risks to inflation, the incomplete pass-through of global energy prices (local petrol prices were increased by 8.7%, diesel prices by 36.9% and kerosene by 49.3% on 12 February), and expected exchange rate depreciation.
"Rising fuel prices and subsidies and possible wage hikes are expected to increase government spending, while a 40% electricity surcharge will likely have strong repercussions for a wide range of industries. Strike action by unions in the transport and plantation sectors in response to fuel price hikes may destabilise business activity in the coming months.
"While headline and core inflation declined in January – to 3.8% and 4.7% y/y, respectively – due to improved supply, we expect inflation to pick up in H2-2012, largely due to the rising cost of oil imports, which account for c.25% of the country’s import bill. More specifically, headline inflation is likely to pick up after February due to the anticipated increase in transport and energy costs (transport and energy have respective weightings of 12.3% and 23.7% in the CPI basket). We raise our forecast for average CPI inflation in 2012 to 6.7% from 6.4% to reflect a gradual rise in headline inflation on the back of moderate LKR depreciation and an oil-price surge," the paper said.
http://island.lk/index.php?page_cat=article-details&page=article-details&code_title=45867
* Growth - inflation trade off emerges
Floating the rupee may not be of much help to fix the balance of payments crisis leaving the Central Bank no option but tighten monetary policy interest rates by a further 75 basis points this year in order to curb credit demand. The bank also faces the prospect of having to make a tough choice between growth and inflation, suggests a new research paper released by Standard Chartered Bank yesterday (Feb. 22).
"The sensitivity of import growth to the exchange rate has been relatively modest over the past five years, data shows. Import growth appears to be more sensitive to global and local dynamics than to changes in the exchange rate. Given that we expect USD-LKR to peak at 119 in Q2-2012, we assume that a substantial drop in import growth as a consequence of LKR depreciation is unlikely. So to avert a BOP crisis, a two-pronged strategy of weakening the currency and raising policy rates is required," said the research papers authors Samantha Amerasinghe and Nagaraj Kulkarni.
"The domestic economy is also still showing signs of growth. The sharp rise in imports of investment goods for ongoing infrastructure projects, which grew 64% y/y in January-November 2011, is indicative of this. As a proxy for import-related credit, we add consumption credit (most of the consumption items bought on credit are imported) to import trading credit. Together, they constitute about 30% of overall credit and were growing at 34% as of end-2011. To reduce overall credit growth to 16% (the central bank’s end-2012 target), growth in both import-related credit and other types of credit related to domestic economic activity needs to be curbed substantially.
Modest LKR depreciation and marginal rate hikes might not be enough to effect such a sharp slowdown in credit demand; such a slowdown would in turn impact growth with a lag.
"If GDP growth starts to slow sharply, the central bank may be less determined to bring credit growth down to the 16% target, which may be indicative in nature. In that case, the CBSL is likely to tread the middle path – moderating credit growth from very high levels but not strictly enforcing the 16% credit growth target, while ensuring that GDP growth prospects are not jeopardised. Our baseline scenario factors in two further rate hikes of 50bps and 25bps in 2012, but we will review this call depending on how quickly credit demand responds to changes in interest and exchange rates. The timing of the hikes will be contingent on two factors: the inflation trend in Q1-2012 and credit growth. If inflation rises or credit growth remains elevated, this could accelerate hikes. Historically, during tightening cycles between 2006 and 2010, the CBSL did not hike rates more than 125bps. However, any change in assumptions on inflation drivers could reduce the number of expected rate hikes for the rest of 2012," the SCB research paper said.
"Aside from addressing high credit growth, the central bank must also face a trade-off between inflation and growth. While the CBSL has maintained its 2012 growth forecast at 8.0%, we have revised down our forecast to 7.1% due to the uncertain global growth outlook, the tighter monetary policy stance and higher oil prices.
"The CBSL faces a policy dilemma arising from downside risks to growth, upside risks to inflation, the incomplete pass-through of global energy prices (local petrol prices were increased by 8.7%, diesel prices by 36.9% and kerosene by 49.3% on 12 February), and expected exchange rate depreciation.
"Rising fuel prices and subsidies and possible wage hikes are expected to increase government spending, while a 40% electricity surcharge will likely have strong repercussions for a wide range of industries. Strike action by unions in the transport and plantation sectors in response to fuel price hikes may destabilise business activity in the coming months.
"While headline and core inflation declined in January – to 3.8% and 4.7% y/y, respectively – due to improved supply, we expect inflation to pick up in H2-2012, largely due to the rising cost of oil imports, which account for c.25% of the country’s import bill. More specifically, headline inflation is likely to pick up after February due to the anticipated increase in transport and energy costs (transport and energy have respective weightings of 12.3% and 23.7% in the CPI basket). We raise our forecast for average CPI inflation in 2012 to 6.7% from 6.4% to reflect a gradual rise in headline inflation on the back of moderate LKR depreciation and an oil-price surge," the paper said.
http://island.lk/index.php?page_cat=article-details&page=article-details&code_title=45867
Last edited by CSE.SAS on Thu Feb 23, 2012 1:22 am; edited 1 time in total
