Pivotal Action

by Asantha Sirimanne

http://www.lankabusinessonline.com/fullstory.php?nid=1374665121

Sri Lanka plans ambitious 7.0-pct deficit under IMF program

July 21, 2009 (LBO) - Sri Lanka is planning a budget deficit of 7.0 percent of its economy under a plan agreed with the International Monetary Fund, which will help improve the country's rating and open the way for foreign financing, a top official said.
The IMF said it had reached a deal to give 2.5 billion US dollars to Sri Lanka with the first tranche of 313 million US dollars to be disbursed on July 24 after formal board approval.

Confidence

"For the government and private sector the confidence building is complete," Central Bank Governor Nivard Cabraal told LBO.

"It will also make borrowing costs cheaper and is likely to have a very significant impact on our ratings."

Sri Lanka has a 'B' speculative rating from Standard and Poor's. Fitch has given a 'B+' rating. Both have negative outlooks. S&P warned that if an IMF loan did not come, the rating would fall further.

"We are planning a 7.0 percent (of gross domestic product) fiscal deficit," Cabraal said.

"We are expecting tourism and imports to recover in the second half of the year."

Sri Lanka originally forecast a budget deficit of 6.5 percent of gross domestic product (GDP) for 2009, but since then state revenues have fallen. IMF later warned that the deficit may balloon to 9.0 percent of GDP.

An IMF loan which is disbursed in tranches as a program reaches benchmarks, keeps a country on a tight fiscal and monetary path, requiring interest rates to increase if revenues or borrowings fall.

IMF managing director Dominic Strauss-Kahn said the government had proposed "an ambitious program aimed at restoring fiscal and external viability."

A 7.0 percent target is tight for Sri Lanka and past experience has shown that the country can survive a slippage unless it resorts to central bank credit to finance the gap.

"The IMF staff supports this program, specifically the government’s goals of rebuilding reserves, reducing the fiscal deficit to a sustainable level, and strengthening the financial sector," he said in a statement.

A responsible government budget is key to economic stability. If the government spends more than it gets and prints money (gets central bank credit) to make up for shortfalls the rupee falls quickly and later inflation also picks up.

A dip into central bank credit last week, which drove domestic interbank liquidity steeply up, sent shivers down the spines of economy watchers last week, showing the importance of tighter budgets.

Cabraal said Sri Lanka was planning 4.0 to 5.0 percent average inflation by end-2009 and "slightly over" 5.0 percent by the year end under the IMF program.

Revenues

Cabraal said a newly introduced nation building tax had produced good results. The tax brought in 4.1 billion rupees in May, the first month of its introduction, the finance ministry said in an interim report.

In the first five months of 2008, revenues were down, 8.0 percent from a year earlier, but improved from a 9.6 percent reversal in the four months to April.

Economic growth fell to 1.5 percent in the first quarter. After remaining weak in the second quarter, the Central Bank expects growth to pick up.

Cabraal said tourism was already looking up. A part of Sri Lanka's estimated two million strong diaspora was also starting to visit the country again, he said.

Though the government has shown a commitment to raise taxes, analyst say cutting expenditures sharply ahead of a possible presidential election next year may be prove tough.

Collapsing imports and a narrowing of the trade deficit was a key cause of the revenue downturn. Value added tax from imports fell 43 percent to 24.1 billion rupees in the first five months of 2009, from 42.6 billion in the same period last year.

But Cabraal said imports were expected to pick up during the latter half of the year. Sri Lanka has a peg with the US dollar and imports are driven by earnings from exports, net inward remittances and capital inflows.

But a large part of the trade deficit is driven by capital inflows and central bank's net money printing. When capital inflows fall, or there is a reversal, the trade deficit falls.

Foreign reconstruction aid can create a fresh surge in imports, even if external demand for exports remain weak, driving the trade deficit and government revenues up.

In the first five months of the year, Sri Lanka's aid pipeline showed signs of narrowing, particularly from traditional Western donors as relations deteriorated suddenly in the last stages of a war with separatist Tamil Tigers which ended in May.

External Picture

IMF money itself goes directly to the Central Bank's balance sheet and is invested externally, usually in US treasuries.

"I would like to call upon the Sri Lankan authorities to work with the donor community to ensure an adequate level of financing for the reconstruction effort to lay the foundation for future growth," Strauss-Kahn said.

Following the float of the Sri Lanka rupee in March as a prior action for an IMF loan Sri Lanka has reversed its reserve losses. Gross official reserves fell from 3.5 billion rupees to 1.1 billion dollars in March.

Foreign hot money has already started to come to Sri Lanka. IMF however cautioned against flighty capital, a reversal of which triggered the 2008/2009 balance of payments crisis.

"Persistently high budget deficits have forced the government to rely on short-term financing from international markets," Strauss-Kahn warned.

"The global financial shock resulted in a sudden stop to this financing, capital outflows, and a significant loss of Sri Lanka’s international reserves."

Sri Lanka is currently on a 'non deal' road show meeting international investors, with a view to raising funds abroad. An injection of foreign money will give significant leeway to the budget.

Cabraal said gross reserves were up at 1,705 million US dollars as of July 20. The number is believed to be significantly in excess of the monetary program discussed with the IMF.

Cabraal said Sri Lanka has not decided whether to go for a bond or a syndicated loan but investors who met a Sri Lankan team were "bullish." Cabraal is due to meet investors in London as part of the road show.

Sri Lanka raised 500 million US dollars through a 5-year sovereign bond. Bonds without exit options are a more stable form of financing and cannot be recalled suddenly. It has to be sold to a third party.

Cabraal said the IMF loan would also help the private sector seek foreign financing. A sovereign rating upgrade implies a strengthening of all other players in the domestic economy.

"For the private sector development activities, expansion activities the way is open," Cabral said.

"This opens huge opportunities for Sri Lanka."

Following the announcement a four year bond maturing on 01.02.2013 fell around 30 basis point in morning trade from 13.05 percent to 12.70 before stabilizing around 12.75/85 levels, dealers said.

Sri Lanka has cut policy rates steeply from 19.0 percent to 11.0 percent so far this year.

Sri Lanka has a peg with the US dollar at 114.90/95 and the country's inflation is de facto anchored to US levels.

Unless central bank prints money to finance the budget deficit effectively engaging in 'quantity easing' analysts say the country's high policy rate bias of 11.00 percent against near zero for USA would help anchor price levels to that of the US.

The rate bias would also be more than enough to keep the rupee pegged at 114.90/95 levels to the US dollar, and build up foreign reserves by sterilizing inflows.