Sri Lanka’s Biggest Policy Overhaul Since Civil War Risks Inflation Bump By Anusha Ondaatjie - Feb 29, 2012

Sri Lanka’s biggest overhaul of economic policy since the end of its civil war risks a bump in inflation while auguring increased stability by aiming to curb the island’s trade deficit.

In less than two weeks last month, Sri Lanka let its currency weaken to a record low by shifting toward a more freely floating exchange rate, raised fuel prices and boosted interest rates for the first time since 2007 to damp credit growth. The moves aim to curb an excess of imports such as oil over exports, as Sri Lanka’s post-conflict resurgence buoys domestic demand.

“Although inflation could spike, the measures taken are good in order to ensure longer-term economic stability,” said Sanjeewa Fernando, an analyst at CT Smith Stockbrokers Pvt. in Colombo. “It’s the biggest monetary and fiscal policy overhaul since the end of the war” in 2009, he said.

Sri Lanka’s foreign reserves have fallen about 25 percent from almost $8.1 billion in July as the trade gap swelled, prompting Standard & Poor’s to lower the island’s sovereign rating outlook to stable from positive yesterday. Fitch Ratings said this week that the depleted reserves have increased balance-of-payments risks.

Consumer prices may rise 6.7 percent on average in 2012 as a result of last month’s policy steps, according to Standard Chartered Plc. They climbed 2.7 percent year-on-year in February, the slowest pace in 28 months. Price pressures are expected to build during 2012 because of “strong growth and imported inflation,” HSBC Holdings Plc said in a note yesterday.
Currency Decline

The policy steps began with the rate actions on Feb. 3, the scrapping of the rupee’s trading band on Feb. 9 and the increase in energy costs from Feb. 12.

The local currency has declined 6.5 percent against the dollar so far this year, the worst performance in the world after Iran’s rial. It slid to a record-low 122.35 per dollar yesterday. The Colombo All-Share index is down 10.2 percent in 2012, the most in Asia.

Governor Ajith Nivard Cabraal’s decision to raise the reverse repurchase rate to 9 percent from 8.5 percent and the repurchase rate to 7.5 percent from 7 percent contrasts with cuts in nations from Indonesia to Brazil, as Europe’s protracted debt crisis pressures officials to shield growth.

The increases in borrowing costs, a more than 20 percent rise in transport and electricity prices and a shift toward a “largely floating exchange rate” make up a “bold” package of measures, said Sajjid Chinoy, an economist at JPMorgan Chase & Co. in Mumbai.
‘Unambiguously Positive’

While they will probably crimp growth and spur inflation in the “near term,” the “reforms are unambiguously positive in the medium term, and will likely ensure that growth is rendered more sustainable going forward,” he said in a note.

Sri Lanka’s $50 billion economy may expand 7.1 percent in 2012, according to Standard Chartered, less than its earlier estimate of 7.5 percent. Gross domestic product rose an estimated 8.3 percent last year, Cabraal has said.

The central bank said last month it aims to keep inflation in the “mid-single digit levels” in the second half of 2012. Credit granted by commercial banks to private businesses jumped by 34.5 percent in December from a year earlier, “substantially” exceeding projections, it said.

February’s steps will help bring down the trade and current-account deficits, Cabraal said on Feb. 14. The International Monetary Fund welcomed the move toward greater exchange rate flexibility in a Feb. 9 e-mail. It has disbursed $1.75 billion from a $2.6 billion program to boost the Sri Lankan central bank’s reserves.

Sri Lanka’s trade deficit exceeded $1 billion in both November and December. Its reserves fell to three months coverage of current-account payments at the end of 2011, from roughly four months in the middle of last year, S&P said.

To contact the reporter on this story: Anusha Ondaatjie in Colombo at anushao@bloomberg.net

To contact the editors responsible for this story: Hari Govind at hgovind@bloomberg.net; Stephanie Phang at sphang@bloomberg.net
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