The Price Signal- SRI LANKA FACING DOWNGRADES, DEFAULT UNLESS CENTRAL BANK IS DISCIPLINED
Sri Lanka will face credit downgrades and possible sovereign default of dollar debt unless the highly unstable discretionary ‘flexible exchange rate’ is restrained and some monetary discipline is brought in.
Next year will be a critical year as budget deficits are set to expand, and the credit system will also go through a cyclical recovery, leading to an expansion in private credit. Sri Lanka is a country that mostly maintained monetary stability during the worst years of the war with the help of the ideology then prevailing. But now each new episode of monetary indiscipline is costing the country one notch in the rating scale. Sri Lanka will soon run out of rating space to tap capital markets if the flexible exchange rate/call money rate targeting continues in the next recovery space.
2020 SRI LANKA IS NOT 2005 SRI LANKA
When Sri Lanka got its credit rating from Fitch in 2005, it was BB-. That was two notches below investment grade. Except for the 2008 downgrade, when inflation and the budget deficit shot up amid a global financial crisis and the war intensified, all other downgrades have been due to monetary indiscipline.
All downgrades since then (including 2018) have come amid an economic recovery because of balance of payments crises triggered by the central bank’s interest rate targeting and/or sterilizing forex interventions. Money printing has worsened in recent years due to more Keynesian interventionism creeping into the central bank and a highly discretionary ‘flexible’ policies being adopted. If money printing is tracked as the stock of central bank credit to government, it can be seen how monetary instability triggered rating cuts. The first downgrade from BB- to B+ was followed by an upgrade in 2011. The upgrade happened just before the central bank triggered another BOP crisis. Fitch stayed put during that crisis, but S&P cut the outlook to negative. Because the rupee was allowed to appreciate after the previous crisis, many foreign investors also stayed put. When money was printed in 2015 to flush markets with excess money and push down rates, and the crisis worsened in 2016, the rating was cut to B+. When the economy was barely recovering from that crisis in the first quarter of 2018, money was again printed by the central bank to target rates triggering another crisis, generating the second bust in a row. In December 2018, the rating was downgraded to B.
BARELY ABOVE DEFAULT
The next downgrade will take Sri Lanka to B-. Sri Lanka will probably be able to access credit markets even at that rating. But B- is barely above C. From two levels below investment grade in 2005, Sri Lanka is now barely above default. The same tricks done in 2005 cannot be repeated now. Sri Lanka’s foreign debt is now much higher. The actual debt position is not known because many state enterprises have borrowed directly, and not through on-lending. Chinese debt has at least built some infrastructure. The sovereign bonds have built nothing. Sri Lanka’s foreign debt is now much higher. The actual debt position is not known because many state enterprises have borrowed directly, and not through on-lending. Chinese debt has at least built some infrastructure. The sovereign bonds have built nothing.
There will be a recovery in 2020 as the credit contraction from the 2018 currency crisis ends. India is also suffering identical effects. In 2018, the central bank’s monetary indiscipline triggered an economic downturn despite the absence of major fiscal slippages. But 2020 will be like 2015; there will be a spike in spending. Any tax cuts will also dampen the recovery in revenues. While income tax cuts bring benefits, indirect tax cuts will not help. There will be a stock market boom and economic recovery. The central bank and others are talking about the need to bring down interest rates. That is not reassuring. A closed economy and import duties will not drive growth up. It is doubtful whether China will give loans like earlier as it is having its own troubles. China’s flexible exchange rate is taking a toll, as are state-owned enterprises. However, China may yet grant debt relief to Sri Lanka.
If rates are cut further and money printed, the recovery will be shortlived, and another currency crisis will be generated, and downgrades will follow. In 2018, rating agencies were more jittery than usual. When growth is weak, there is a tendency for rating agencies to downgrade quicker. The economic fallout from the 2018 currency crisis is similar to that of India’s currency collapse. Unlike Argentina Sri Lanka’s central bank got away with lower inflation due to tight liquidity at the expense of an output shock, like the better-managed countries during the East Asian crisis. If there was more excess liquidity an Indonesia or Argentina style meltdown may have occurred. However, the advantage was not utilized to appreciate the currency during the credit downturn. The proposed central bank reforms will not help, as it will be more of the same monetary indiscipline with the flexible exchange rate and flexible inflation targeting. Argentina also had flexible inflation targeting at an absurdly high double-digit rate. What is the point of having a double-digit inflation target?
The difference between India and South America is that Latin American countries end up in sovereign default due to their exposure to debt markets and weak ratings. Sri Lanka no longer has the rating space for either monetary indiscipline or fiscal indiscipline.
Dollarisation and Golderisation
None of the candidates of the 2019 presidential elections is seriously talking about monetary discipline, though there is some understanding about the dangers of currency depreciation. If there is no serious monetary discipline, all talk of economic programs is meaningless.
In South American countries like Argentina, most individuals have dollarised to protect themselves from frequent currency crises, even if the government has not officially dollarised. In Vietnam, the currency was fast collapsing until the 1989 central bank reforms that paved the way for economic growth, that people dollarized their salaries and bought gold, which the State Bank of Vietnam (SBV) calls golderisation. Despite 20 years of monetary stability, people are still at it and the SBV is trying to discourage it.