Does the success of the 10 year Sovereign Bond with lenders oversubscribing ten times and at a rate of interest of 5.875% which is less than the previous bond rate last year and also less by almost 1% on the rate paid on the Bank of Ceylon bond of 6.875%, shows the confidence of the international investors in our economy? Not quite, for with the three rounds of Quantitative Easing (money printing) in USA and the EU, their economies are flushed with funds seeking outlets for investment. This surplus money can earn less than 1% in those countries and hence our Sovereign Bond is very attractive to investors in the western economies who are looking for alternative places to invest their surplus funds.
There is also a shortage of government bonds in the capital market in Asia which also drew funds to our Sovereign Bond. The bond subscribers however will not necessarily hold these bonds until the 10 year maturity but will sell them in the secondary market to high net worth individuals and Investment Funds who are short of such paper in their portfolios. The premium or discount on these bonds in the secondary markets will show the continual confidence in our economy relative to other bonds in the market.
Is there a foreign debt trap?
Should we then be carried away by the success in the issue of the Sovereign Bond? Not really because the underlying deficit in the current account of the balance of payments was $ 1,061 million which was 7.8% of the GDP. We cannot afford to run such large deficits continually. In fact economists say the sustainable current account deficit is only about 3% of the GDP.
How will the proceeds of the Sovereign Bond be utilized? In October the previous bond issued in 2007 for US$ 500 million will mature and part of these proceeds will be utilized to repay it, says the Treasury Secretary. He also hinted that they may be used to stabilize the rupee. This will be a repeat of the earlier error. The total amount of foreign debt repayments for this year is given by the Central Bank as "Govt. Loan Repayments: US$ 1.4 bn" and Sri Lankan Investments outside: US$ 0.5 bn. The authorities say that our foreign debt level is not dangerous since the Debt/GDP ratio has come down below 80%. But according to the Fiscal Management( Responsibility) Act of 2003 the Debt/GDP ratio should be reduced to 60% by 2013.
Can we achieve this requirement?
The debt issue is that we are dependent on raising new foreign loans to repay maturing foreign debt. This is somewhat like a pyramid scheme where new deposits are raised to repay maturing loans. It is undoubtedly a risky situation. The only way to avoid such a situation is to generate a large surplus in the Capital Account where large foreign inflows particularly Foreign Direct Investment will give us a surplus in the overall balance of payments. We must also earn more foreign exchange from exports and foreign remittances to be free from this foreign debt trap.
The Central Bank expects much foreign capital inflows. FDI, including loans, increased to US dollars 1,066 million in 2011 compared to US dollars 516 million in 2010. Our best bet to overcome problems in debt repayment in the coming years is to increase foreign capital inflows particularly in equity investments. Our Foreign Exchange Reserve in May 2012 was US$ 5,000 million or so. And it does not permit the Central Bank to use these Reserves to bolster the rupee. If we can meet the deficit in the balance of payments on current account from a surplus in the Capital Account this year and the next few years, we are unlikely to face a debt crisis for the next two to three years because most of the previous loans from international agencies were at very low rates of interest.
Problems in excessive foreign debt
But significant net inflows of foreign capital can create other problems. These capital inflows lead to the appreciation of the rupee which undermines the competitiveness of our exports. Where the exchange rate regime is flexible, real appreciation of the exchange rate is due to appreciation of the nominal exchange rate. Where the exchange rate is fixed, real exchange rate appreciation is due to a rise in inflation after the money supply increases. As foreign capital inflows increase they increase the money supply. Appreciation of the real exchange rate undermines competitiveness, widens the current account deficit, and increases vulnerability to a financial crisis. Significant appreciation could also lead to a sudden drying up of capital flows, causing an abrupt adjustment of the current account. Beyond its negative effect on domestic investment, significant appreciation of the real exchange rate could thus create major problems for macroeconomic management. Moreover, significant increases in capital inflows can make the financial system more vulnerable and overheat the economy as suggested recently in the report by Standard & Poor.
The Central Bank has encouraged the commercial banks to borrow in foreign currency and to use such money to lend locally. The Bank of Ceylon raised $ 500 million which it seems to have swapped with the Central Bank. But the risks inherent in such borrowing remain with the Bank of Ceylon. Lending booms which often follow increased capital inflows, increase financial system vulnerability (a) by worsening maturity mismatches between bank assets and their liabilities, and in some cases mismatches between the currencies in which banks lend and borrow, and (b) through associated asset price bubbles.
Macroeconomic overheating can be provoked by accelerated economic growth and inflation, and particularly by appreciation of the real effective exchange rate (REER) as happened in 2010 and 2011. The problem of preventing the appreciation of the REER will pose a challenge to the Central Bank whether it follows a fixed rate or a floating rate of exchange.
The Causes of the BOP crisis
No developing country can or should isolate itself from the world economy. The benefits of outward looking policies take advantage of the possibilities of international trade and capital inflows. Mr. Lalith de Mel well known Company Chairman, has argued against such policies But the experience of many countries show that integrating with the global economy leads to faster economic growth. But linking itself to the world economy exposes a country to what are termed external shocks. The Capitalist economies are always subject to the business cycle. The world economy experienced a recession in 2008/2009 and recovery is still not complete. Our exports in 2011 were $ 10.6 billion, an increase of 22% over the previous year despite the over-valued rupee. Export prices then were higher. The average export price index of coconut products and rubber increased by 38.1 per cent and 43.5 per cent, respectively, while the average tea export price index increased by 5.4 per cent in 2011. The increase in export earnings however was due largely to increase in industrial exports.
The Central Bank projection for export earnings in 2012 is $ 11.7 billion. But our imports increased in 2011 to $ 20.3 billion, an increase of 51% compared to the 2010 figure of $13.5 billion. Why did our imports go up so much? Petroleum imports in 2010 were $3 billion but in 2011 they were 4.8 billion. The average import price of crude oil increased by 36.6 per cent to US dollars 108.59 per barrel during the year, compared to US dollars 79.52 per barrel during 2010, a 37 % increase in price and another 30% increase in volume. The volume of petroleum imports, crude oil and refined petroleum products was driven by higher demand for thermal power generation.
The expenditure on fertilizer imports increased by 69.5 per cent to US dollars 407 million in 2011, led by higher prices that prevailed in the international market and increased volume of imports as the fertilizer subsidy was extended to cover all crops, effective from May 2011. It is time to review the fertilizer subsidy which is a heavy drain on the budget.
Expenditure on wheat and maize imports also increased by 62 per cent to US dollars 429 million. Import price index increased by 22.4 per cent in 2011 reflecting an increase in price of all major import categories. Import prices of the food and non-food category increased by 9.1 per cent and 24.8 per cent respectively. If not for the Central Bank holding down the rupee, the inflation in food prices in 2011 would have been much more. Motor vehicles imports increased by over 86% to US $ 1.9 billion; Gold imports increased by over 6 fold to US $ 604 million).
Outlook for 2012 and beyond
The World Economic Outlook of the International Monetary Fund (IMF) show that the global recovery is markedly uneven, with rates of growth in advanced market economies several percentage points less than those in emerging countries. Price inflation remains low in advanced economies where unemployment is high and excess capacity is considerable. But world commodity prices which were in decline in 2011 could rise as the world economy recovers. The World Bank has warned of higher volatility in commodity prices during 2012.
The Central Bank has given a rosy picture for the external sector in the years ahead. It projects the current account deficit to come down to 0.2% of GDP in 2015. It has not shown how these projections were arrived at since the breakdown of exports, imports and foreign remittances are not given. But it is difficult to project without taking into account the developing situation in the world economy.